Market commentary August 2006

Following other interest rate peaks since 1913 (when the US Federal Reserve came into being) the average US stockmarket returns were negative in the 12 months following. That makes sense. They stop raising interest rates because it is anticipated that the economy will slow, and the stockmarket in turn begins to discount the fall in profits by going down. So the peak in interest rates is not necessarily a positive for the stockmarket in the year ahead.

Corporate profitability has been improving apace for a number of years. For example, constituents of the S&P 500 in the US have just had the 12th consecutive quarter of double-digit earnings growth, which is very impressive. But stockmarkets have not gone up in line with profits, making the US stockmarket look increasingly good value, at least in theory.

Similarly, we previously highlighted that the price earnings ratio (a measure of stockmarket value) is lower now for the UK stockmarket than it was at the stockmarket trough in March 2003, suggesting that, on this measure, it is better value now (above 5800) than when the FTSE 100 index was below 3500 in 2003.

It is worth grappling with this apparent paradox. Most of us think that if the stockmarket is at 3500 it must be good value, whereas at 5800 it is necessarily less good value. But the way the market works is not this one-dimensional. It depends on the profits being earned by the companies that make up the stockmarket, and, more importantly for most investors, the dividends being paid out. So if profits and dividend pay-outs doubled since the stockmarket was at 3500, the stockmarket index would have to go to 7000 for the same “good value” to be maintained. But the stockmarket has been lagging the impressive advances in profits, making the stockmarket at 5800 better value than it was at 3500.

Albert Edwards of Dresdner Kleinwort (perhaps the only long term pessimist who has both survived and stuck to his guns since the “irrational exuberance” episode,1996-1999) believes that this is what should be happening, because in a low inflation world equities will have to be valued more cheaply. He expects price earnings ratios to go somewhat lower, so even if profits growth continues, the stockmarket will lag behind. In fact he is more pessimistic than that, and expects profits and equities to fall to fulfil his more gloomy predictions.

This feels much too gloomy to us, but it balances some of the recent over-enthusiasm. We believe that the stockmarket correction which began in May is not over, so in the short term the market could become even better value, which is very encouraging for those with cash burning a hole in their pocket.

STOP PRESS. The interest rate rise in the UK this morning (3rd August) may have already gone a long way to curb the over-enthusiasm of recent weeks.