The bulls are back in town: Have investors jumped back into the market too early? Tom Stevenson and Terry Wilkinson report

THE stock market has never been noted for its tact. Last week, as the country wrung its hands about rising unemployment and the Prime Minister told critics to stop doing Britain down, the FT-SE 100 soared to an all-time high of 2,922.1.

The market's behaviour last September was no better. London share prices leapt for joy when sterling, to the acute embarrassment of the Government, bade a premature farewell to the ERM.

Since then the FT-SE 100 has risen by 27 per cent, tempting the private investor back into the market in a big way for the first time in years. Sales of personal equity plans are booming and unit trust sales are at their highest level since the crash of 1987. Disenchanted with dwindling returns on his building society deposits, the small investor is chancing his arm with shares again.

Peter Reynolds, director of private client business at Birmingham stockbroker Albert E Sharp, said he had three clients call him up on Friday, saying they had pounds 50,000 on deposit they had not told him about previously and asking what they should do with it.

As usual, however, small investors seem to have missed the boat. Mr Reynolds rues the fact that those who need income most are always the last to switch.

'If only they had told us six months ago. We are in the unusual situation when you can get higher income from a safe utility than from a building society deposit. But it's getting too late for Aunt Agatha to switch. The professionals have already been there.'

The surge in share prices since Black Wednesday is being sustained by the hope that a combination of sharply lower interest rates and a devalued currency will resuscitate the sick UK economy.

Like most of what happens in the stock market, it is a gamble. But last week there seemed to be at least some evidence that it was coming good. Investors cheerfully seized on a monthly monetary report from the Treasury, which cautiously noted economic activity might have been running higher than expected at the time of the Autumn Statement in November.

Retail sales had been on a firmer tack, the Treasury said, the public's holdings of cash had been rising, and the demon inflation looked to be at bay as retail goods inflation - which excludes volatile food, drink and tobacco price movements - turned negative in January. A rise in new home starts so far this year and a 16 per cent annual increase in new car registrations in February, despite doubts about dealers' figures, helped the positive mood.

The German Bundesbank, although failing to cut its important discount rate from its current level of 8 per cent, did shave its repurchase rate from 8.5 per cent to 8.25 per cent, enabling the pound and the London stock market to end the week on a buoyant note.

For almost six months, investors have been buying into the London stock market, certain, like Mr Micawber, that something was bound to turn up.

It is not just the big pension and insurance funds that have been buying. If private-client firms can be believed, the small investor also saw recovery coming.

David Jones, of Sharelink, said activity started rising last summer. In January, business doubled. Capel Cure-Myers also reported a rise in turnover, with private investors increasingly disenchanted with the available returns on cash deposits in building societies.

But can it last? With the notable exception of the Japanese broker Nomura, the consensus in the City is that the market does not have much steam left.

Most watchers think the market has come to the end of its run for the time being, and one stockbroking house thinks it will move downwards for the next two years.

Since sterling's devaluation on 16 September, the market has worn rose-tinted spectacles. Conditions have been perfect for rising share prices, with two important shifts.

First, interest rates have been allowed to fall to 6 per cent. That reduces the cost of borrowing and gives customers more spending power.

The second key change has been the 15 per cent devaluation of sterling against leading currencies in the past six months. A weaker pound makes UK companies more competitive, because their products are cheaper abroad. It also means overseas earnings are worth more on repatriation.

That is more important now than ever, with the 100 biggest quoted companies earning 45 per cent of their profits overseas. Perhaps a quarter of all quoted company earnings are made abroad.

That is the good news. Analysts' caution stems from the belief that in the absence of concrete evidence of recovery, in the form of higher corporate profits, the market is looking too far into the future.

Jerry Evans, of NatWest Markets, draws a parallel with last year's early surge on Wall Street, which saw the Dow Jones index rise nearly 20 per cent between December 1991 and April 1992.

The main impetus came from the US authorities, who slashed interest rates by whatever amount was needed to reactivate the economy. Recovery is only just starting to show through in company results and economic statistics.

'It is quite likely that the UK market will show a similar pattern over the next nine months or so, gyrating in a narrow band around current levels. There is a lot of hope and not much substance,' said Mr Evans.

NatWest Markets expects the FT-SE index to end the year at about 3,000. It is within 100 points of that now.

That view is borne out by a widely used measure of the stock market's value, the p/e ratio, which compares the price of a share with its earnings. NatWest's expectation of earnings growth of between 15 and 18 per cent this year puts the stock market on a prospective p/e ratio of about 15, falling to 13.5 by the end of 1994.

That is quite high by historical standards. During the past 20 years, that rating was matched only in 1987, when the p/e ratio was over 20 and unsustainably high - as the crash that October proved. During the Eighties, the rating averaged 10. 'Only in three years' time does the market begin to look reasonable value,' Mr Evans said.

Mark Brown, at UBS Phillips & Drew, also expects the market to tread water for the rest of the year. 'Too much of the good news about earnings growth is in the price already.' He has targeted 2,900 for the end of the year and expects a fall to 2,700 in the meantime.

He pointed out that earnings growth expectations assumed a rapid return to the profit margins companies were achieving in the boom year of 1988. He said that was asking a lot and that earnings growth this year would be a modest 12 per cent.

Mr Brown also thinks the market is high enough on the basis of its p/e. 'You would expect the market to be on a higher rating than during the Eighties, when inflation and interest rates were higher, but the gap is now too great,' he said.

Even more important than the market's p/e ratio, he thinks, is the yield offered by shares. The poor return on cash deposits has encouraged a shift into equities where investors are attracted, in the absence of superior income, by the possibility of a capital gain.

Currently shares provide a gross income of about 4 per cent, which compares favourably with the return on building society accounts and fixed-interest bonds, but is lower than the historic average for equities, of nearer 5 per cent. In the bull run of 1987, the yield on shares fell to just 3 per cent, but that was considerably lower than at any time since 1971.

'Anyone expecting the index to reach 3,500 is looking at a yield of 3.5 per cent, and there will be resistance to that.'

With the Government facing a borrowing requirement of perhaps pounds 50bn during the next fiscal year, Mr Brown anticipates a rush of rights issues to beat the issue of gilts later this year. That will further brake share prices.

Mike Grimble, an investment strategist at Norwich Union, agrees rights issues will hold the market back, and thinks the consensus forecast of 3,000 for the FT-SE by year-end is about right. But he remains fairly positive on the prospects for shares next year.

'Profit margins will be better than expected, as unit labour costs reduce. There should be a long-term decline in German interest rates, which will be positive for the rest of the world and should give the UK Government scope to cut rates here. Earnings could grow by 20 per cent this year and 15 per cent next,' he said.

Nomura's forecast that Footsie will touch 3,500 by the year-end remains the joker in the pack. Tony Broccardo said: 'We are in a change-over period, with the baton shifting from recovery hopes to earnings growth. We expect 22 per cent this year, although 30 per cent is possible, and 25 per cent next year, which will keep on dragging the market up.

'Cost-cutting has been a big factor in recovery this year, and next year there should also be volume growth. Equities are good value compared with gilts, and on a forward p/e of 11 in 1994, are not highly rated.'

If, as most analysts appear to believe, the market is probably going nowhere for the rest of the year, the challenge for investors now is to read correctly which sectors will outperform the rest of the market.

The danger is of buying into sectors where recovery is already in the price. Building companies, for example, have run their course and there is certainly no recovery yet.

Robin Aspinall, one of the most bearish analysts in the City, who expects the FT-SE index to fall to 2,650 this year, thinks utilities are likely to be some of the best performers this year. 'In a low-growth, low-inflation environment, dividends are not going to grow much, so the relationship between gilts and equities is going to change in favour of gilts. The only shares worth buying are pseudo-gilts with good yields.'

(Photograph omitted)