Beware the third up-tick

LAST Friday's move by the Federal Reserve to raise short- term interest rates in the US by a quarter of a point was the first monetary tightening for five years. The decision shows a determination to keep inflation down now that the American economy is recovering. It may also indicate that Alan Greenspan is worried about the growing bubble in global financial assets.

Whatever the reasons, the increase in rates is a sign of a possible change in the so-called golden scenario of strong economic growth coupled with low inflation.

Many professional investors believe that the first up-tick in interest rates is not too worrying. They expect the market to have a correction and then recover.

They believe that the third up- tick is the one to worry about. Three increases in succession might be enough to arrest the mania for equities and encourage American investors to switch their money from mutual funds back into cash deposits.

I am, of course, concentrating on American investors because their attitude is the key to the level of world markets. It is the overspill from American mutual funds that is fuelling the explosive rise in emerging markets and underpinning the strength of those in Europe.

CAUSE FOR WORRY

This time around, I think it would be unwise to wait for three up-ticks before taking defensive action. There is no need to panic out of the market - it is quite possible that in a week or so the Fed's first move will soon be seen as prudent and good for the long term. However, a second up-tick would be a cause for worry, especially as so many people interpret three up- ticks as a strong bearish signal.

In March last year I wrote an unequivocally bullish article headed 'The case for a continuing bull market'. At that time the FT-SE 100 index stood at 2,957 against more than 3,400 today.

In my first article this year I was more cautious and recommended holding 15 per cent in cash and 20 per cent in gold shares. I said that I might move this either way as 1994 unfolded. It is beginning to unfold, so now I would increase the cash holding to 25 per cent.

I suggest that, as you review your portfolio, you weed out the shares with a poor relative performance and those that are obviously highly speculative. In a raging bear market some shells and bio-tech stocks will look absurd. Who wants to know that Timothy Bloggins is going to do great things with a company if the shares are four times asset value, there are no earnings and fear is in the ascendant?

Generally speaking, I believe in running profits and cutting losses. This way you always enjoy large profits and suffer small losses instead of the other way round.

However, the profits should only be run when a rising share price is supported by improving fundamentals. For example, two recommendations of mine, Amersham International and Motor World, have both recently reported excellent results and further growth is predicted.

I always sell when the story changes. For instance, if I had owned the shares of Proteus International a fortnight ago I would have been inclined to sell them when I heard that UBS had resigned as financial advisers.

UBS disagreed with the directors of Proteus about the timetable for eventual profits. So far Proteus has had a string of large and growing losses. It may discover something very special one day, but meanwhile it is the kind of share that will collapse in a bear market and the UBS resignation does not bode well for the next essential rights issue.

I also sell when a company's share price loses relative strength. Although I did not recommend Betterware to Independent readers, it was a good example of this happening. After a glorious run the shares began to falter and then to fall in a rising market. This was a clear case of a share losing relative strength despite rising earnings and a strong cash position.

RULE OF THUMB

Another reason for selling is when a share price performs well but goes too far ahead of the fundamentals. Here I use the PEG factor to measure whether or not the share has become a sell. I divide the future growth rate into the prospective price-earnings ratio and, if the result is over 1.5, I sell the shares.

I am not able to advise readers regularly on when to deal in the shares I recommend in this column. I do, however, urge you, yet again, to run profits and cut losses.

As a rule of thumb I suggest cutting losses when any shares I have recommended fall 25 per cent from the highest price reached since you purchased them. Losses are an unavoidable part of active investment. However careful you are in selecting shares, there are bound to be some upsets.

With my recommendations so far, the losses (which have been cut) have been much more than offset by the very substantial profits (which have been run).

Mr Slater is an active investor who may hold any shares he recommends in this column. Shares can go down as well as up. Mr Slater has agreed not to deal in a share within six weeks before and after any mention in this column.