Business Analysis: Why the stock market is defying the UK's gathering economic gloom

The headlines have been unremittingly grim. House prices tumble in June. Profits warnings rise. Oil hits new high. Terror comes to London. And yet shares have soared to levels not seen since March 2002. Why are stock-market investors apparently seeing the world in such a different way?

One of the reasons is that the headlines and the UK stock market reflect slightly different bits of the world. Another is that investors have got used to reading such headlines, expecting the worst, and then finding that the eventual economic out-turn is not so bad.

It is certainly true that consumers have begun to draw in their horns. From their biggest ticket items - their houses - to the smallest - whether to pick up the latest clothes - people have been putting off their purchases. A glance at our table shows that retailers have been the worst-performing blue-chip stocks so far this year, but they account for a relatively small part of the overall index. The biggest housebuilder is not even a member of the FTSE 100.

The ability of the global economy to absorb the price of oil and other commodities has confounded sceptics for most of the past two years. Demand from industrialising China and gas-guzzling America means that the oil price is high for a reason, so the situation is not analogous to the oil shocks of the Seventies. And best of all for the UK market, BP alone accounts for about 10.6 per cent of the FTSE 100, so its shares have soared with its oil-based profits.

Richard Batty, at Standard Life, saiddomestic issues were no impediment to the UK stock market making further advances. "Oil is driven by the high oil price and natural resources stocks overall comprise 25 per cent of the UK market. London has the largest weighting for commodities for any market in the world."

All the heavyweight sectors are doing well, in contrast to previous years where telecoms or banks have been depressed. Only banks, which account for 20 per cent of the UK index, would be seriously affected by a collapse of consumer confidence or the housing market, since lending would stop and bad debts might rise - but the consensus is that banking shares are too cheap to ignore.

Ian Scott, at Lehman Brothers, is resisting the temptation to reassess his bullish call on equities. Indeed, yesterday he upped his prediction for the year-end value of the FTSE 100 from 5,100 to 5,500.

"Although there may be a pause for breath," he said, "fundamentally there appears little to cloud the sky. Profitability is exceptionally high across almost all sectors. The oils and banks contribute to the high level of profitability, but of the 13 broad sector categories, only health care and media are generating a lower return than the 18-year average."

All of which adds up to a consensus that the stock market looks cheap. This is especially marked relative to bonds, which have been driven up by demand from pension funds so that the yield on a bond is worse than the dividend paid by many FTSE 100 stocks. Add in the earnings that are reinvested in the company, and equities look compelling value.

A Lehman Brothers analysis suggests that the equity market is a long way from recovering the confidence it lost during the 2000-03 bear market. Investors' enthusiasm for accentuating the negative has proved misplaced time and again.

Mark Burgess, at Legal & General, said: "Oil, housing and profits warnings notwithstanding, the global economic news is surprising on the upside and that is supporting the market."

Certainly, the indicators of future economic growth, which dipped in spring, are bouncing back. Other fears from a few months back have also dissipated.

The talk in the spring was that hedge funds, poleaxed by a run of poor results and facing rising interest rates, would shut down, making them forced sellers of shares. This does not appear to have become a widespread phenomenon.

And while UK travellers to the US may not have cause to cheer the rally by the dollar, investors certainly do. For starters, this has increased the purchasing power of the big US value investors who hunt for share-price bargains on this side of the Atlantic. And, as Rolf Elgeti, at ABN Amro points out, it has been useful in other ways.

"The weak dollar had played a significant part in all the financial meltdown scenarios which people talked about being triggered by America's twin deficits," he said, so its reversal reflects a growing sense of confidence that imbalances can be worked through. "The dollar strength has helped here, because a lot of European companies are heavy exporters to the US and this has increased their competitiveness and their margins."