Boom or bust: can share prices keep on rising?

The market rally offers a chance to take stock of equity portfolios, says James Daley

Slowly but surely, the UK stock market is closing in on the record high it hit on the final day of 1999. Having burst through 6,000 two weeks ago, the FTSE 100 index of leading shares came close to 6,200 on Thursday, just 700 points below the levels last seen seven years ago.

But there are worrying echoes of the final months of the stock-market boom of the late Nineties - in particular, the irrational exuberance over internet stocks. Two weeks ago, for example,Google bought YouTube for $1.6bn (£856m).

Last time internet companies were being bought for silly prices, the stock-market rally proved unsustainable - in the three years following the December 1999 high, share prices almost halved.

The good news this time is that experts believe a protracted bear market is unlikely. Ben Yearsley, an investment specialist at independent financial adviser Hargreaves Lansdown, says share-price valuations are much more reasonable than seven years ago.

In 2000, the average FTSE 100 company had a price-to-earnings ratio - a common way of measuring a company's value in relation to its annual profits - of more than 25. Today it is around half these levels.

"If you look at the FTSE 100 today, it's trading on a price-to-earnings ratio for next year of around 11 or 12 which, however you look at it, is not very expensive," says Yearsley. "Especially when you're getting a 3.5 or 4 per cent dividend yield from many of those stocks."

Yearsley points out that the mid-sized and smaller companies have had a much stronger run over the past three years and no longer represent such good value. But he believes prospects for the larger companies remain good. To take advantage of those prospects, he recommends investors opt for an investment fund such as Artemis Capital.

Charles Deptford, manager of Baring Asset Management's UK Growth fund, also thinks larger companies are keenly valued, adding that the very largest corporations are also likely to be most resilient. However, he has concerns for the short-to-medium term.

"The market is certainly in a much better place than it was in 2000," he says. "But I do have issues about it going much further from here - we've had a pretty good run, a long period of profit growth from UK companies, and I don't think that can continue indefinitely.

" Central banks are tightening monetary policy and growth isn't easy to find. Margins are high, and it's hard to see them not coming down. There's also a bit of speculative merger and acquisitions activity in the market which will eventually come to an end."

There have been an unusually high number of M&A deals over the past year. In the latest takeover, Thames Water was sold to Macquarie, an Australian investment bank, for £8bn.

Speculative investors such as hedge funds have been taking aggressive positions in many of the UK's largest stocks in the hope that they will be rewarded with a takeover deal.

Phil Doel, the manager of F&C's UK Opportunities Fund, believes there is no reason why this trend should not continue for the foreseeable future. For companies not in the M&A spotlight, he believes conditions will get tougher.

"The problem with UK plc at the moment is that margins are quite high, so in order to create value, you need to generate top-line growth, and that's difficult to sustain," he says.

Doel believes the share-price highs of recent weeks have been driven by the falling oil price and an easing in inflationary pressures. But he believes investors' enthusiasm is now likely to fade. He thinks it is likely to be the 20 largest companies that will struggle.

"These mega-caps are in sectors such as banking, pharmaceuticals and oil which are facing pressures in terms of growth, rising costs and seemingly continuous regulatory scrutiny," he says.

"If the market goes into freefall, the defensive nature of these companies will mean they perform relatively well but, this aside, there aren't many compelling opportunities in the large-cap space."

Deptford and Doel agree while long-term prospects for the UK are sound, the best opportunities lie in individual stocks. Both believe BP's shares have been hit too hard by a recent string of negative newsflow, and are likely to recover from their current slump.

If you're not a specialist investor, the best way to get access to the UK market is through mutual funds, where professional managers make the stock-picking choices for you.

Patrick Connolly, a financial adviser at Towry Law JS&P, says less specialist investors should not get carried away trying to pick funds that specialise in certain-size companies or certain sectors. He adds that it is important to spread your money across a number of asset classes and geographical regions.

Connolly tends to allocate less of his clients' assets to UK equities, as they have a tendency to be correlated to European and US stock performance.

If you're invested in UK mutual funds for the long run, the consensus of opinion is that we are not currently experiencing a bubble. At a stock-specific level, however, some shares are at greater risk of taking a knock. Now is a good time to take a close look at exactly where you have your money invested.

Share picks from the experts

* As well as believing that BP presents a great buying opportunity at its current value, F&C's Phil Doel says he is also keen on SSL, the maker of Durex condoms, which has been going from strength to strength in recent months, and which will be resilient to any cooling off in the economy.

* Baring's Charles Deptford says investors looking for a defensive stock could do worse than Royal Bank of Scotland, which he says has been undervalued for a long time. Its share price has picked up in recent weeks, rising from £17 to £19 since the end of July, but still looks cheap and comes with a healthy dividend yield.

* Deptford adds that it's worth avoiding the utility sector, where prices have reached exorbitant levels, driven up by the expectation of more consolidation.

* Lesley Duncan of Standard Life Investments says Invensys, which develops controls and automation systems, remains amongst her favourite mid cap stocks at the moment. She says its exposure to booming markets such as oil and gas, and the rail business are driving its growth, adding that the company has been a great recovery play since its restructuring and refinancing earlier this year. * * Duncan is also keen on food manufacturer Tate & Lyle, which after undergoing a change in management and refocusing in recent months, now has a very strong momentum.

* Ralph Brook-Fox of Resolution Asset Management is more optimistic than many of his peers, about short to medium term prospects for the UK market. As a result, he says he has not merely been chasing defensive stocks. One of his favoured picks is mortgage bank Northern Rock. Brook-Fox says he believes the housing market is well supported and will continue to grow over the coming months.

* Another of Brook-Fox's favourites is aerospace and engineering group Meggitt, which is benefiting from the boom in international air travel.