Heading for an almighty fall

Forget the election for the moment, though it seems to have given the stock market one of its traditional bouts of pre-election jitters, down 2.5 per cent since Mr Major announced the election on Monday last week.

The big news of the week for investors was also the smallest. The US Federal Reserve's decision to raise interest rates by 0.25 per cent on Tuesday was hardly unexpected.

Alan Greenspan, the Federal Reserve chairman, has been hinting that a rate rise was coming for some time, given the strength of the US economy and the dangerous signs of overheating in the stock market.

But it was still a significant step. The move was enough to put the temporary brakes on Wall Street and inevitably spilled over in the UK stock market as well, adding to the attack of pre-election nervousness.

Although most attention is now focused on what happens if Labour does achieve the kind of landslide victory that the polls suggest - I repeat my prediction that in the short term it will be good for gilts, but dodgier for shares - the more serious risk to the market, in my view, remains the much bigger question about the level of stock markets world-wide.

It may seem bizarre to harp on about what is happening in the United States all the time, but the fact is that there is something like a two- thirds correlation between how Wall Street moves and what happens to the London market.

Whichever party happens to be in power, it is inconceivable that the London market could advance very far if there was a serious decline in Wall Street.

We all know that the market in the States is highly valued by historical standards, but the question is how far and at what pace it returns to a more normal level, as eventually it must.

Mr Greenspan is clearly trying to make it as orderly a retreat as possible. His objective is to try and keep the economy moving along at a fair clip without creating a dangerous bubble in asset values.

The danger of a stock market crash is not simply the disruptive effect on the economy, but the scope for error that it creates for policymakers.

Last week's interest rate rise was a precautionary move designed to give some credibility to Mr Greenspan's earlier warnings about the dangers of excessive optimism building up in the stock market. The Fed chairman has so far displayed a pretty sure hand on the tiller.

But he is still walking something of a tightrope, in which one mistake could be fatal.

Why do I say this? Well, one reason is to go back and look at the long- run historical record again. One expert on the stock market who has done just that is Peter Bernstein, whose book on risk, Against the Gods, I recommended just before Christmas.

In his professional career as an economist, Peter likes to remind his institutional investor clients of the longer-term patterns at work in the stock market.

I am grateful to him for permission to reproduce the graph that appears with the column this week.

What the graph shows is the long-run growth rate in equities and how the market tends to trade in bands around this long-term trend. (For statistical buffs, the central line shows the long-term average growth rate, and the upper and lower bounds one standard deviation above and below this rate.)

You can see quite clearly that Wall Street is now at the very upper limit of its long-term trading parameters. The risk that the market will fall or that it will go on rising are no longer symmetrical. The former is much more likely than the latter.

Now the good news, says Peter, is that the market is quite capable of trading at the upper end of its range for quite a long time, as it did for example in the 1880s, 1900s and 1950s.

The bad news is that, on every occasion bar one, the market has breached the upper limit of its trading range, it has always fallen back eventually - and not just to the past average, but to the lower band of its trading range.

If that were to happen now, the US market would need to fall by the order of 35 per cent from its current level.

Put another way, the US market today is already 10 per cent higher than it would be in four years' time if it had simply grown at its historical average over the past few years.

Either way the conclusion seems pretty clear cut: the market is now dangerously high.

It doesn't mean that you should not be investing in equities, since the right shares will continue to do well in any environment, but it does mean that the risk of the overall market dragging down your performance is higher than for a long time.

Of course, one fashionable counter-argument is that something profound has happened to change the normal parameters within which the stock market is valued. The obvious candidate is the transformation of inflationary expectations in the past 15 years. Logically, that should be good for nearly all types of investment, as it has proved to be.

But, says Peter, it overlooks the secondary question of how far the market should adjust to reflect this new reality.

He points to two things that are wrong with this kind of analysis. One, it ignores the fact that in the past when inflation was next to non-existent (a state of affairs we have not yet reached, incidentally, with UK prices still rising by 3 per cent per annum), the stock market often still grew only at its average long-run rate - of 6.6 per cent a year in real terms - not at anything higher.

The second thing is that if inflation is set to fall to those kinds of levels, it means that bonds, which are still offering high yields in real, inflation-adjusted terms, must be a much better bet than equities. They would offer an equal or potentially higher return for much less risk.

In other words, if shares are fairly valued, then bonds are undervalued: if bonds are fairly valued, then shares are overvalued. I have no doubt, though I have not yet calculated the figures, that the same kind of analysis applies to the UK market. I can only echo Peter's conclusions: "Our advice to owners of equities: proceed at your own risk."