Bull market in suspense
NICHOLAS DAVENPORT
No one is likely to suggest that this column has as much influence on investors as, say, the City column of the Daily Mail with its mass circulation, but the curious fact is that I began to assail the bull market on 20 September last year—under the title 'Equities up on cloud nine'—when the Financial Times index of industrial shares was 518. I then asked—'ls the market taking leave of its senses?' Well, the index went up to 522 the day before publication and that was the top. It came back to 475. 'Down from the clouds' was my title on II October--and a correspondent wrote con- descendingly: 'Don't worry : it is only a minor correction in a long-term bull market.' But on 20 December I plucked up courage to write 'Farewell to the bull market.' More letters fol- lowed of a ruder sort as the market was then making a strong recovery —it actually touched 520 in January—but it flopped to 470 by 21 February—a fall from the top of 10 per cent. (As I write it is 478.) This, in my view, is not a big enough correction for a market which went too high.
The usual mathematical test the City applies when it makes up its mind as to whether an equity market is too high or too low is the average price-earnings ratio (the multiplier of the last reported earnings per share). In Wall Street the conventional 'safe' ratio is around 17: when it is over 20 the market is considered dear and when it is over 25 the market is thought dangerously high. This cannot be translated literally to Throgmorton Street be- cause British equities are historically less dynamic than American. In my view the 17 should be 15 for our market and the 20 should be 18.
The average price-earnings ratio in Sep- tember last year, when the Financial Times index was 522, was 23. It is now 19} after the correction. Of course, you do not expect the best 'growth' shares to conform to the average. If an aggressively managed company is pushing up its earnings per share at the rate of 20 per cent per annum you would expect that share to be valued in the market at a price- earnings ratio of 24 when the average is 19. But in September last year the popular growth shares were being quoted at 40 to 50 times their last reported earnings! Even today, after the correction, you will find good 'growth' shares selling at a price-earnings ratio of 20 to 30.
In a free capital market a bull position in equity shares is usually corrected by a change in the technical supply-demand relationship. When a company sees its shares selling at an inflated price-earnings ratio of between 30 and 40 it finds it cheaper to raise more capital by an equity 'rights' issue than by a bond issue. This happened in a big way in 1968. According to the Midland Bank records ordinary share issues jumped from £72.6 million to £363.7 million in 1968 while bond issues fell from £313.8 million to £181.3 million (convertrbles rose from £30 million to £128 million). The fact that this huge increase in the supply of
equity shares did not begin to affect the market till towards the end of September was due to the offsetting increase in demand from the unit trusts. The average investor, as we all know, was becoming scared by the perpetual fall in the purchasing power of money and was handing over his life savings to the unit trust managers for employment in the equity share markets. Even the Trustee Savings Banks, the Public Trustee, the joint stock banks trustee depart- ments and the family solicitor were all moving in the same direction. The result was a fantastic jump in the unit trust net demand for equity shares from £84 million in 1967 to £258.5 mil- lion in 1968. But it was not quite as large as the jump in the new supply.
What accentuated the demand for equities and kept the bull market running longer than I expected was the spate of mergers and take- overs. Not only does the merger hand out cash to the shareholders taken over, which will be -re-employed in the equity market, but it often reduces the supply of shares dealt in. The volume of mergers and takeovers last year was somewhere in the region of £3,000 million, but the net effect on demand in the equity market was probably an increase of £200 million.
It will be observed that when I said farewell to the 'bull' market I did not hail the start of a 'bear' market. If you believe in the long-term future of the British economy—and you may well have doubts about it until a decent work- ing relationship between trade unions and
managements is achieved—you will believe in long-term 'bull' market in equity shares. There will alwaYs be companies with first-class managements who will be showing satisfactory growth as the economy expands. But every 'bull',market gets over-excited and has to have its period of rest. As one broker has pointed out in his market report, the best prices of 1947 were not regained until 1950, the best of 1955 not till 1959, the best of 1961 not till 1964: nor were they substantially exceeded before 1967.
When I suggested that the market correction had not gone far enough, I had in mind that the rate of growth in company profits in 1969 will be slowing down. Last year the average growth was between .15 per cent and 20 per cent. A firm of brokers who have been employing an economics professor to estimate the 1969 growth was between 15 per cent and 20 per cent. year, that is to say, it will be between 71 per cent and 10 per cent. Here, then, is a mathe- matical test for an individual equity share. Assume that the growth of a well-managed company will be 10 per cent, take off 10 per cent from the published price-earnings ratio, and if it is above 17 the share is still too high; while if it is below 17 it is reason- ably priced.
I believe this is not the start of a 'bear' market for two reasons. First, there is stilt no end to the wage-cost inflation. Last year retail prices went up by just under 6 per cent, weekly wage rates by 6 per cent and weekly wage earnings by 7-j per cent. The current wage claims suggest that wage earnings will keep ahead of retail prices. Secondly, -there is still no end to the international monetary crisis. The franc remains over-valued and the German mark under-valued. A sharp devaluation of the franc this year could upset sterling and set in motion a further rise in sterling prices. So the urge 'to get out of money into 'real' (equity) values may remain strong. The City cannot therefore see a 'bear' market starting unless (a) the budget gives a shock—corporation tax rising from 421 per cent to 45 per cent or more —and (b) there is a firm prospect of the return to power of Mr Harold Wilson.
Previous page
