Outlook: Stock markets

AT THE beginning of last month, this column advised a "sell in May and go away" stance on equities. Since then shares have fallen quite sharply on Wall Street and then rebounded again. This week's sensationally good inflation figures from the US seem to confirm that there is no stopping this long bull market. Once again the bears are made to look foolish. Even Alan Greenspan, chairman of the US Federal Reserve, now suggests no more than a gentle tug on the tiller - "modest pre emptive action" - is required to prevent a resurgence of inflationary pressures in the soaraway US economy.

So should investors be piling back in? Over the long term, shares always perform well as an investment, returning on average some 7 to 8 per cent a year in real terms for the past two or three hundred years. This average holds good for any 70-year period you care to take, but within a 70-year time frame there are often very considerable variations - prolonged periods of overperformance followed by years of underperformance.

Most of us do not invest on anything like a 70-year time frame, so contrary to received stock market wisdom, it does matter when you buy shares. Those buying just before the crash of 1929 would have waited many years before seeing the value of their capital restored and it would only have been quite recently that their money would have established the trend 8 per cent average rate of return.

We are now many years into one of those sustained periods of overperformance - indeed this is close to being the longest such period ever. This fact alone would demand extreme caution from here on in. But even if we accept that bull markets and business cycles don't die of old age - that they have to be killed off by some event - very strong nerves are required to invest at these levels.

To justify present Wall Street valuations you have to believe that something fundamental has changed in the world and particularly the US economy, that this prolonged period of overperformance in equities is about to be backed by an equally long period of overperformance of gain in productivity.

For the 1990s as a whole, these US productivity gains are nothing to write home about, but it is true that spurred on by the communications revolution, they have picked up quite markedly in the last few years. However, even if something special is indeed happening, is this present period of technological change more important than past ones - the industrial revolution, the introduction of electricity, the telephone, television or automobile? Almost certainly not. In other words, it remains quite improbable that equities are about to establish a step change in their long term rate of return, moving up, say, from the old rate of 8 per cent to 10 per cent or higher.

And if this is true, then there is a serious misallocation of capital taking place in the US economy right now, both in technology, where any Tom, Dick or Harry can obtain finance if their company name ends in dot.com, and in the stock market, where investment continues to be made on the assumption of 20 per cent plus returns. There's no telling when it will end, but end it will.