The stock market and its manifest absurdities

A respected manager of pension funds in the City says that stock markets in this country and in the US may be displaying the most serious over-valuation of assets this century.

So Tony Dye, the professional investor who holds this view, arranges the pounds 51bn he manages in cautious fashion. Only 64 per cent of the assets for which he is responsible are held in equities compared with 80 per cent normally; 14 per cent of his pension funds are in cash. This is what you do in the stock market when you expect a fierce storm to blow.

If there were to be a big crash it would be more serious than at any time since the war, because private investors on both sides of the Atlantic have more at stake than used to be the case. In Britain successive privatisations of state-owned companies have increased the number of private investors. The move to portable pension funds has had the same effect; these may be managed professionally but they feel more personal than membership of a company pension scheme. Likewise, savers have put substantial sums into unit trusts in recent years. Thus a sharp decline in stock market prices would make many people poorer and would have the same dampening effect on consumer confidence as a decline in house prices.

A crash would also have political consequences. It would make it almost impossible for the Conservatives to persuade the electorate that they had managed the economy well.

Markets collapse either to correct a great absurdity or to register a great shock. At a certain point in the late Eighties house prices began to appear absurdly high in relation to average salaries; people used to look at the valuation of their own homes and say that they were glad they had bought them some years earlier because they could not have afforded them today. That was absurd and eventually prices declined. And in all markets, whether of pictures, metals, gold, houses or shares, there is a mechanism which produces periodic over-valuation or under-valuation. Greed makes people buy because prices have fallen and for no other reason. At the top or the bottom, some news event turns away the last optimist or the last pessimist and the correction begins. In stock markets this signal is classically a change in interest rates. This is why professional investors are watching the Federal Reserve Bank in New York so intently; later this week it may push up interest rates for the first time after a long decline.

Under the heading of great shocks come such events as outbreaks of war - the Vietnam War, for instance, ended a 20-year period in which all foreign exchange rates had been tied to the dollar - or wild swings in commodity prices such as oil, or natural disasters. The Kobe earthquake left a dent in Japanese share prices.

I do not see a manifest absurdity in share valuations either in London or New York. Certainly there has been a long rise in share prices in both market-places and ratings are high. A minor correction is probable.

But on the primary test of "what returns do shares provide?" there is nothing untoward. The average dividend on UK stocks is 3.75 per cent; and if companies were to distribute to their shareholders all their profits and plough nothing back, then this return would rise to 6 per cent. In the context of a growing company and subdued inflation, there is optimism here but no danger signal, no amber or red lights flashing.

The pessimists, however, have been examining a much more sophisticated valuation system, and its results scare them. It is called Tobin's "q" and it compares what it would cost today to replace companies' stock market valuation. On this basis, looking right back to 1920, stock market ratings have hardly ever been higher.

In other words, investors are valuing factories much more expensively on the stock exchange than it actually costs to erect them. Physical assets are no longer much of a guide. Successful companies are often people and computer screens; and their value may be in their brand names. It would be impossible to calculate Microsoft's replacement value.

Mr Dye is 48 and says that anyone over 40, having been through several stock market cycles, has to be pretty cautious about what is going on. If Mr Dye were ten years older still, he would have been through the only big stock market crash this country has experienced since the war. Between the summer of 1973 and the winter of 1974, the stock market fell all the way back to levels last seen in the Thirties. The least of the causes was the correction of a previous over-valuation. Much more serious were external shocks such as a doubling of the price of oil, a banking crisis and the return of a Labour government that legislated to hold down prices and dividends.

Many boards of directors thought their companies were on the way to bankruptcy. There were crippling strikes and hints of civil unrest in the air. In the City there was gallows humour: should one be hoarding tinned food in one's garage? That was a real bear market. Today's concerns, with or without Tobin's "q" are minor by comparison. All of which may yet leave Mr Dye exceedingly embarrassed and the pensioners whose money he controls rather unhappy.