Never mind the slowdown, shares can still ride high

The story has been the same for months. Regardless of how much depressing economic data is released showing how consumers have stopped spending and house prices are stagnating, stock markets have continued to rise.

But how? Surely the value of investments shouldn't be soaring at the same time as everyone frets about the economy? Should we be looking forward to a repeat of the booming Nineties with rocketing share prices, or are we heading for financial meltdown?

Most economists agree the predicted rate of UK GDP growth needs to be revised downwards in the wake of the marked consumer slowdown on the high street, high oil prices and lower house price rises.

In fact, the UK economy was growing at an annual rate of just 1.5 per cent in the second quarter of 2005, according to figures compiled by the Office for National Statistics. That means growth was at its weakest level since 1993.

Even the Chancellor, Gordon Brown, has admitted economic growth in the UK is unlikely to reach his forecast of 3-3.5 per cent this year, in the wake of soaring energy costs.

On Wednesday, the Organisation for Economic Cooperation and Development (OECD) cut its forecast for the country's growth from 2.4 per cent to 1.7 per cent this year.

The caution has been due to the combination of recent rises in interest rates to 4.5 per cent - from historic 50-year lows of 3.5 per cent two years ago - and a cooling down of the booming property market.

According to George Buckley, chief UK economist at Deutsche Bank, the Bank of England's monetary policy committee needs to cut interest rates over the coming months to reinvigorate consumer demand. "We're not in recession territory but I'd expect interest rates to be cut to stimulate the economy," he says. "The question no longer appears to be if the Bank will cut rates again, but when. Our central case is for a 0.25 per cent cut in early 2006."

As far as house prices are concerned, Mandy Bradley, director of website Propertyforecasts.co.uk, believes values will actually start to rise over the coming months. There's no evidence, she insists, to suggest the market will crash.

"Over the coming year, we are forecasting increases of around 6 per cent, although there will obviously be a considerable variation between regions," she says. But, while this is encouraging, average values were growing at double this rate during 2004.

It's a gloomy economic picture, but there's much better news in the stock markets. Since plunging to less than 3,300 points in March 2003, the FTSE 100 index of leading shares has staged a recovery and has now risen by over 60 per cent. Even coming from a low base, this is a strong turnaround better than most people predicted.

Oliver Cadogan, of Batterymarch, manager of Legg Mason's UK Equity Fund, agrees the picture looks muddled, but insists there are clear reasons why the markets appear to be so out of kilter with the rest of the economy.

"The sight of a rising FTSE All-Share index this year, against a backdrop of slowing consumption, house prices and lending, looks like a contradiction in terms on the face of it," he says. "However, the Footsie's strong performance can be mainly attributed to its large oil, gas and mining exposure, as well as the out-performance of more defensive sectors such as the larger pharmaceuticals, utilities and tobacco companies."

An analysis of official FTSE data illustrates his point. Just four sectors - oil/gas, banks, telecommunications and pharmaceuticals - account for around 60 per cent of the index. If these perform well, the entire market will be lifted.

The soaring cost of oil this year - which rose to over $60 a barrel - has meant a boom for the industry's giants and their investors. BP's share price rose 40 per cent from £4.90 at the start of 2005 to £6.86 by the back end of September.

The boom in international merger and acquisition activity has also played its part, says Peter Reid, Britannic's chief investment officer. In the wake of the dot.com bubble bursting five years ago, he says, many companies had to slim down their businesses and concentrate on the best ways of generating revenues.

"Balance sheets have been very strong as companies spent a couple of years restructuring," explains Reid. "They have been using that cash to buy back shares and take each other over, and this has been positive for the market."

Drinks giant Pernod Ricard's £7.4bn acquisition of Allied Domecq, and the proposed £7bn merger between Boots and Alliance UniChem have hit the headlines recently. Even rumours of M&A activity can boost share prices.

Add in the fact that many of the large cap companies trading on the FTSE 100 earn a large percentage of revenues in overseas markets, and you can see why the markets look so healthy.

While there is a risk that the stock market is now too high, the fact remains that companies are in a healthy position, borrowing is still cheap, and valuations don't appear unreasonably high. Unless there's a major shock to the system, the investment community is not expecting a downturn in the markets anytime soon. However, that's not to say some companies won't encounter problems.

The key to success, believes Paul Cavendish, manager of the Cavendish Opportunities fund, is picking the right stocks. Much of the negative sentiment in the market, he adds, has centred on retail companies which have been hit by the consumer slowdown.

But Nick Wells, product director at Artemis, says it's possible to make positive returns on your money in any market - as long as you entrust your savings to the best fund managers.

So what is the next year likely to hold? Should investors feel upbeat or fearful about the future? According to Julian Chillingworth, chief investment officer at Rathbone, the best way to be is cautiously optimistic. Given the economic backdrop, he believes the FTSE 100 is likely to remain steady at around 5,400 points. "We are probably going to see a slower rate of economic growth than has been enjoyed in previous years," he says. "The real problem would come if oil spiked to $100 a barrel."

Stocks to watch in a bull market

If markets continue to soar, it's worth looking at the companies that have enjoyed increases over the past year. If the rises are due to high energy costs, for example, having exposure to oil stocks would be advisable, say leading fund managers.

BP - it has been a major winner during 2005, with tremendous profits.

Shell - for similar reasons to BP, revenues are likely to rise .

Royal Bank of Scotland - looks cheap and there are rumours of share buybacks.

Standard Chartered - it is likely to be a beneficiary of decent Asian growth which should accompany strong equity markets.

Kingfisher - on the basis that it is now very low and could start to improve.

Stocks to watch in a bear market

When markets are falling, you either need to get out completely or stick with reliable, defensive companies that can be relied upon to generate decent levels of cash, regardless of the economic backdrop.

BT - a solid cash-generating business which provides decent yields.

Vodafone - along similar lines to BT, a reliable large cap performer.

MMO2 - the public's love affair with mobile phones is unlikely to lose its passion.

Rolls Royce - has a longer business cycle, so not so affected by short-term market movements.

Meggitt - this FTSE 250 engineering company is involved in more stable industries, a good bet in difficult times.

Diageo - demand for drinks (it produces Guinness and Bailey's) is unlikely to be hit by market turbulence.