Focus on good quality shares and you won't go too far wrong

The maturity of the current bull market in equities was brought home on New Year's Eve when a British Gas engineer , a propos of nothing, least of all the heating he had come to fix, began expounding his investment philosophy. His thoughts were a timely reminder of the old adage about shoe-shine boys on Wall Street - when the gas man cometh with share tips a crash must surely be around the corner.

His enthusiasm for shares brought to mind another, no doubt apocryphal, tale from 1929 when a lift-boy at JP Morgan plucked up the courage to ask the great man himself what he thought the market would do that day. "It will fluctuate, boy, it will fluctuate," was the banker's considered response.

Morgan's message was that a proper investor, as opposed to the speculator he rightly assumed the boy had become, tried not to worry about the state of the stock market but focused on good quality individual shares. Anyone who lived through the bear market of the early 1970s, however, knows that not even the best shares can shrug off a determined sell-off.

Between the spring of 1972 and the end of 1974, the stock market lost almost three quarters of its value, so it is no wonder at the end of a year in which the Dow Jones index rose by 27 per cent, dragging the London market up on its coat-tails, that it is not just gas engineers spinning out their overtime who fret about the direction of the market in 1997.

To put things in perspective, if the London market were to stage a re- run of the early 1970s, the FTSE 100 index, which closed 1996 at a record high of 4118.5, would bottom out shortly before the millennium celebrations at a low of 1,112.0. If bull markets are said to climb a wall of worry, they don't get much steeper than that.

In an election year when the first change of government in 18 years looks probable, with investors struggling to acclimatise themselves to an economy which threatens to have discovered steady growth without inflation, and with stock markets on both sides of the Atlantic flirting with record highs, it is no surprise that the City is sharply divided on the future direction of share prices.

The bear argument is essentially this: Wall Street is grossly overvalued on a number of measures - according to one, the aggregate value of stock market quoted companies is now for the first time ever greater than the total US gross domestic product. As a result, the Dow will almost certainly experience a sharp correction sometime soon and, while London is not so pricy on fundamental measures, the two markets fortunes are so closely entwined that a fall in the US will inevitably spill over here.

Talk to Smith New Court's Andrew Smithers, one of the Square Mile's dourest Jeremiahs, and he will paint you a convincing apocalyptic vision of an overheating UK economy, fuelled by the failure of Kenneth Clarke in at least the last two Budgets to raise taxes or cut spending. Fiscal and monetary policy are out of balance, he says, and interest rates will have to rise to make good the shortfall. That will prick the economic bubble, sterling will fall, and the door will open for Britain's old enemy stagflation. The market will end the year well below its current level.

The problem with that sort of view, apart from the fact that for most of the past 75 years it has been wrong, is that it doesn't sell shares. No surprise then that Mr Smithers, and his bearish cohorts in the fund management business like PDFM's Tony Dye, are the exception rather than the rule. For the rest of the City, a watered down version of the bullish line taken by NatWest's Bob Semple is the favoured safe option.

Mr Semple's view is that an incoming Labour government will inherit an economic environment many of us thought we would never see in our lifetimes: solid economic growth, low inflation, falling unemployment and the external account in broad balance. Gordon Brown's first budget will set a prudent fiscal policy (with one eye on keeping Maastricht options open) and an aggressive upward move in interest rates to 7 per cent will take the edge off consumer spending.

That should ensure a longer-lived economic cycle, inflation will fall back towards the Government's 2.5 per cent target in the second half of the year and gilt yields will fall. The equity market, already underpinned by continued strong earnings and dividend growth, will look increasingly cheap and large amounts of institutional cash sitting on the sidelines will push the market to new highs, possibly 4,600 by year-end.

The truth probably lies somewhere between the Semple and Smithers scenarios and we would expect the FTSE 100 to close 1997 at around 4,300 and the Dow Jones index, driven by rising earnings and a maintained rating, at close to 7000. The Nikkei, which has threatened recovery for four years now, will have another indifferent 12 months.

Consumer stocks will continue to benefit from rising high street spending, benefiting retailers, leisure companies and the brewers. Growth stocks will struggle to repeat the last two buoyant years and high yielders, the market's dogs during that time, will have their day. The gas man will still be reading the Investors Chronicle and the market will still be fluctuating, boy.