Lack of appetite for minnows to keep shares looking sweet

The market is no respecter of anniversaries, but exactly 10 years after shares peaked before 1987's October crash the parallels are worrying.

As happened a decade ago, pre-election monetary fudges have turned up the heat under the consumer economy, and shares, despite yesterday's 72- point retreat, are testing uncharted territory.

One measure of the market compiled by BZW compares equity prices with their long-term inflation-adjusted growth trend. According to that historic yardstick, shares are almost 50 per cent overvalued at their current levels. That sort of exuberance has been matched on only two occasions in the last 80 years - on both, the overvaluation heralded damaging bear markets.

New worries to contend with this time include interest rates on an upward trend and a sharp hit to earnings forecasts as a result of the strength of the pound. Thanks to Chancellor Gordon Brown's Budget raid on the nation's pension funds, the value of dividends to the market's biggest shareholders has also been sharply reduced. It is no wonder the Jeremiahs calling the top of the market are gaining support daily.

Look a little more closely, however, and the backdrop to the recent stock market surge is very different from a decade ago. Inflation is low and (outside the London property market) seemingly under control, growth is strong and equity valuations are underpinned by falling bond yields around the world. Champions of the bull market, arguably under way for almost a generation since 1974, believe the rise in shares has not run out of steam yet.

Possibly the biggest difference between 10 years ago and now is the lack of depth to the current bull market. As the chart below shows, most directors of companies outside the FTSE 100 index would laugh at any suggestion that share prices were overvalued. The FTSE 250 and Small Cap indices are back where they started the year - for all but the top flight, it's a case of bull market, what bull market?

The meteoric rise of the FTSE 100 index since the beginning of the year has been driven almost exclusively by the strength of the financials sector, with a supporting role played by the drugs companies. The desperation of institutions to obtain a weighting in the newly converted banks has driven sector valuations to unprecedented levels.

With the financial sector representing almost a quarter of the value of the FTSE 100 index, it is becoming increasingly divorced from the rest of British commerce and an unreliable guide to the strength of the stock market as a whole.

Another reason to remain sanguine about equities is the absence of the froth which characterised 1987. That year, the market was awash with ambitious takeover bids including British & Commonwealth's for Mercantile House and MEPC's for Oldham Estates. The Reichmanns took on the Canary Wharf development in London's Docklands - to cap the madness, a merger of Midland Bank and advertising agency Saatchi & Saatchi was mooted.

Rights issues were also 10-a -penny a decade ago, with Robert Maxwell raising pounds 630m to bid for US publisher Harcourt Brace and keeping the cash anyway after the takeover failed.

The folly of the times reached a peak with the infamous pounds 837m Blue Arrow rights issue for the takeover of Manpower. With the market awash with increasingly dubious paper, the 1987 crash was a disaster waiting to happen.

This year is quite different. Despite temptingly high market valuations, there has been an almost total dearth of the new issues and cash calls which can drain institutional cash at the fag-end of a bull run. One explanation, according to BZW, is the distracting effect of the the general election and the wave of demutualisations, which have made conditions for traditional issuance less favourable than they might otherwise appear.

But the key factor is the absence of appetite for smaller capitalisation stocks, cyclicals and highly rated "growth" stocks. These are the typical suppliers of new equity and as long as the market continues to favour defensive shares such as the banks and pharmaceutical companies, equity issues are likely to remain a rarity.

Add to that the increasing prevalence of share buy-backs and the number of shares available has fallen recently. Against a backdrop of big investing institutions awash with cash, and a shrinking gilt market, that provides a compelling technical argument for most of the share market to go even higher.

Goldman Sachs agrees with that generally bullish prognosis. It characterises the current stock market backdrop as an "equity sweetspot", which it defines as a combination of rising growth and falling bond yields. The American bank expects rising growth and stable inflation to continue pushing shares higher.

According to Goldman Sachs, equity values are sustainable for two main reasons - lower inflation expectations and rising economic growth. Inflation expectations for the G6 economies have fallen this year, driving bond yields down. Lower inflation also means investors are willing to accept a lower risk premium for holding equities because the quality of companies' earnings improves.

Importantly, Goldman Sachs believes there is no clear link between equity sweetspots and the valuation of the market. Once the economic fundamentals are in place, shares are driven higher regardless of valuations.

So what does this mean in practice? It is a moot point how much the overall level of the stock market should matter to investors at all. Research shows that jumping in and out of the market is a sure way to miss out.

Look at a chart of the stock market over the past 25 years and the crash of 1987 is a barely noticeable blip.

The most successful stock market investors buy good shares and hold them forever. A correction in the valuation of the market's largest companies looks possible at some point this year, but that is no reason to be out of equities.