Hamish McRae: Black arts and brave hearts

It was another of those weeks on the markets, with shares now down to a five-year low.

It was another of those weeks on the markets, with shares now down to a five-year low. The sense of despair that always accompanies a savage bear market is taking hold, the mirror image to the elation that was associated with a bull one. Or rather with the final stages of a bull market, for in the early stages there is always a balance of the arguments as well as a balance of sentiment.

It is only in those final bull stages that the pessimists begin to lose confidence in their judgement. And that is perhaps the best way to understand the situation now. The bulls are beginning to lose their confidence and are talking of yet more declines before a recovery can begin.

Some basics. The raw material of share prices – the bedrock that ultimately underpins them – is the ability of the companies who issue them to generate profitable growth. Profitable growth requires, of course, both a growing world economy, and conditions that allow companies to benefit from this. Thus the long market boom of the 1990s saw both the longest period of uninterrupted growth the US had experienced since the Second World War, a period of reasonable stability in inflation and falling interest rates. It was a great combination and well-managed companies did well for a long time.

And now? Well, there is no doubt that some sort of world recovery is taking place. You can see how the industrial production of the Group of Seven largest developed countries has perked up and most of the information coming through suggests that the recovery will be sustained. You can see the pattern of growth in the left-hand graph. We have had a downturn of similar magnitude to that of the early 1980s, worse than the early 1990s but not as bad as the mid-1970s. But in each case there has been a recovery: the sun also rises.

Not all evidence, however, suggests that this will be a strong recovery. Start with the US because Wall Street will determine what happens to markets worldwide. Just on Friday early results from the US survey run by the University of Michigan showed that consumer confidence has taken its worst hit since the attacks of 11 September. It seems this is largely the result of falling share prices. Since the main thing sustaining demand has been US consumption, the danger of a vicious circle has increased: falling shares reduce demand which cuts profits and leads to a further fall in prices, and so on.

If that survey was discouraging, just at the same time there was some encouraging news: the profit figures from the US engineering giant GE. Second-quarter profits were up 14 per cent and the company expects the third quarter to be up by 25 per cent. This is important, partly because GE is seen as the bellwether for US Inc, but also because the market has to see rising profits through the rest of this year if it is to sustain its present valuation.

In the middle graph you can see what has been happening to US profits quarter-by-quarter last year and this. In the first three months of the year profits were down on the lower base of the year before. The second quarter is the one that is expected to be up a tad. That is expected to grow sharply through the rest of this year so that by the end of the year profits will be running nearly 40 per cent up on 2001.

The US market has been ignoring this turnabout: it does not want to hear good news. This recovery, noted by ABN Amro, is good news that has been overshadowed by the corporate scandals. The investment bank points out that there is a good fit between the market and earnings, though there have been times (such as the 1987 crash and the emerging markets crises in the 1990s) when shares fell despite rising profits. Conversely during the internet/telecom bubble shares rose despite falling profits.

Still, sooner or later shares should respond. There is one other question that would-be bulls have to tackle. Is the absolute level of US shares still too high? The bear case is shown in the right-hand graph: a price/earnings ratio of over 40 and a dividend yield of only about 1.5 per cent. On that basis, US shares are still very over-priced by the standards of the early 1990s.

The half-answer to that is the p/e ratio calculation is itself a bit of black art. Different houses make different calculations and you can claim it is anything between 20.5 and 41.5. (Do you, for example, subtract the losses of companies making losses from the ones making profits, or do you simply not count them at all?) But it is only half an answer. It is hard to argue that US shares are cheap by long-term historical standards. The possibilityis that the market, having overshot on the upside, will now overshoot on the down.

What about us? The UK market is cheaper than the US one, with the p/e now below 20. But it would be naïve in the extreme to think that it can make headway if Wall Street continues to head down. There are a couple of practical difficulties we face. The first is the adverse tax treatment of pension fund investments introduced by Gordon Brown in his first budget. That looks a serious error now and will have to be reversed by a future government. The other is that falling prices may encourage further liquidation of stocks as funds have to switch to fixed interest securities to protect their solvency position. If the market falls a lot further there will be wonderful investment opportunities for the brave. Trouble is, there are not many brave about.

Markets always turn in the end and a bear market that lasts more than two years is extremely unusual. What is happening now is once-in-a-generation stuff – with all the dangers of dislocation that result. Intuitively, I would guess there is more bad news to come, but not much. Meanwhile the further the markets fall the greater the opportunities – if only for the brave. Interesting times.