Dialogue: Sagging world markets test the cult of equities

The prolonged bear market has broken the investment template, argues HAMISH McRAE.

Good morning. Different year, different ideas about investments?

To get last year's bear market into perspective, it was only the second time since the Second World War that British share prices ended down for two years on the trot.

The previous time was 1973-74, a period of economic catastrophe, when inflation was surging, the miners were on strike and Prime Minister Edward Heath had put the country on a three-day week.

By contrast, this bear market has occurred at a time of continuing economic success.

Yes, the United States, Japan and Germany are all in recession but Britain seems likely to escape it.

There might be some justification for a bear market in the rest of the world, but much less so in Britain. So what is the story?

Actually there are two stories, a short one and a longer one.

The short one is that all the main equity markets are driven by similar features. The pool of investment funds is pretty much a global one and most large companies are pretty global in the balance of their activities.

Thus, only when a country's performance seems particularly good, such as Japan in the 1980s, or bad, such as Japan in the 1990s, is its equity market likely to diverge from the norm.

So as the world economy recovers, as it eventually will, expect British share prices to recover, too.

Actually, most major world markets have done pretty well since September and the immediate question is to what extent this can be sustained until there is evidence that company profits are recovering, too.

HSBC has a nifty computer model to predict movements of the FTSE 100 and this suggests that the market should be back to its December 1999 peak of just under 7000 by the end of 2004.

But, and now we move to the longer story, if that is right it will mean share prices will have made no overall progress for five years. That is not in the brochure.

We are now in a world of low inflation, maybe zero inflation, and conceivably falling prices.

What is the point of investing in shares at all when, in this financial climate, bonds offer a more secure and higher flow of income?

This bear market may well now be over in the sense that prices will not revisit their September lows and by the end of this year will be up on the level they are now.

But it may also signal a great historic turning point: end of the cult of the equity that has dominated investment strategy since the 1950s.

Most portfolios, instead of being dominated by equities with some bonds added for income, will be dominated by bonds and leavened by some equities for growth.

To some extent this is already happening. Boots's pension fund caused a stir a few months ago by switching its entire portfolio into bonds, and HSBC expects that British pension funds will move from their present 70 per cent weighting in equities to about 50 per cent.

The more that such funds shift, the greater the drag on share prices and so the greater the pressure on other funds to shift.

The pressures on funds to move have been increased by the stealth tax on dividend income introduced in the last Parliament.

The shift to bonds has been given impetus by the humiliation of most investment analysts, who not only did not warn of the danger of a bear market but actively tipped shares of companies that were about to collapse.

There is more than a suspicion that analysts were influenced by the fees their employers were earning from giving corporate advice.

Might this switch to bonds mean that investment will become more routine, more boring?

Well, no, because the opportunities for thoughtful investment in bonds are now probably greater than the opportunities in equities.

The great advantage that investors in bonds have over investors in equities is that their relative price is determined to a large extent by the rating agencies that operate on a mechanical, rear-view-mirror basis.

By applying equity-style analysis to the bond market, it should be possible to spot poorly rated corporate bonds that are backed by perfectly sound companies.

Conversely, it should also be possible to give an early warning when a company is about to suffer a deterioration in its financial performance, and accordingly put its bond rating at risk.

This assumption that equity-style analysis applied to bonds will lead to above-average returns presupposes that the analysts are independent. But expect independence to be increasingly prized in the years ahead.

So the messages of this longer story of the great bear market are two-fold. First, investors have faced the most serious challenge for a generation to their assumption that equities offer better long-term returns than bonds.

It may well be that quite often in the years ahead equities will produce higher returns than bonds. But the consensus in favour of holding most of a portfolio in shares is broken.

And second, the credibility of the professional investment community has been shattered. Very highly paid analysts advised investors to go on buying Enron shares when the company was about to go under. You cannot do that to people and expect to be trusted next time.

And so this year all the mainstream houses are predicting that shares will end higher than they began.

They probably will. But those saying this are the same people who said the same last year - and were wrong - and the year before that - and were wrong.

The great divide in the investment community is between bears and bulls, or between equity enthusiasts and bond buyers. It is between advocates and judges.

The place is full of advocates: clever people who create arguments to buy (and very occasionally) to sell shares.

There are far fewer judges: people who are paid for their long-term nose about the likely performance of investments.

For the last couple of decades power has been with the former. Expect the two years of falling prices to start to shift power back to the latter.

And expect this shift to carry on for - who knows? - maybe another couple of decades. About time, too.

- INDEPENDENT