bull market may have steam left

Bull market may have steam left for an upward surge

By Tom Stevenson
Last Updated: 1:03am BST 11/09/2007



The human brain is not good at processing large amounts of contradictory information. It needs a "story", a conceptual framework in which to place the torrent of confusing data to which it is constantly exposed. The world may not be black and white, but we need to pretend it is to understand it.
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That is why a journalist's job is to exaggerate and simplify, to tell a complex tale in a simple way, good news or bad. It is frustrating to a reader who is familiar with the underlying nuances, but it fulfils a deep human need for clarity.
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The investor's challenge is similar because there is no simpler distinction than between buying and selling an asset. You may be battling to weigh conflicting evidence but at the point of the transaction you must pretend to be 100pc bullish or bearish or you cannot act.

At any one time, there are reasons to be gloomy and reasons to be cheerful about the market, but because we can't handle our thoughts being torn in two directions at once we must be optimistic or pessimistic or we will be caught in the headlights. Often, with no real change in the backdrop, our view can swing rapidly from one to the other.

Benjamin Graham, the legendary American investor and mentor of Warren Buffett, expressed this neatly. He said the market is like your neurotic business partner. On some mornings he is feeling on top of the world and he offers you a high price to buy out your share of his business. On others he is depressed and will accept a low price for his share.

Except in a minor way, the underlying value of the business does not change while he makes these wildly fluctuating offers.

The lesson from Graham's story is that investors should seek to buy the market when it is most downbeat and to look to sell shares when it is most optimistic.

Mr Market's moods are all over the place at the moment. On Friday, he took one look at US employment figures and collapsed at his desk in a funk of depression. If the Fed were to cut interest rates sharply next week, he might spring to his feet again.

A headline-grabbing note from the European strategy team at Morgan Stanley illustrates how dangerous it can be to be caught on the wrong side of a shift in Mr Market's mood. It asks what might happen if we were to pull through the current financial turmoil and see shares start to rise again.

Its controversial answer is that we might see a spectacular change in sentiment leading to a "mania of epic proportions".

That possibility is not as far-fetched as it might sound. It is after all exactly what happened nine years ago when financial disaster was averted at the time of the 1998 Long-Term Capital Management collapse and the stock market embarked on a final explosive burst towards its 2000 peak.

The reason the market took off is because it shifted from one simple but pessimistic "story" - systemic financial collapse leading to recession - to another simple but optimistic one - the cycle is dead, the internet changes everything, this time it's different.

Morgan Stanley's argument is that it wouldn't take much for that mindset to return. It believes the "story" will be the rise of emerging markets. Just as happened at the end of the 1990s, the final leg of the bull market will see a return of all the features that usually mark the surge to a peak and which have been noticeably absent this time around.

These include big retail buying of equities, lots of acquisitions, increased corporate confidence leading to a boom in capital investment and finally an expansion in valuations to excessive levels.

What I find compelling about this argument is its honest acceptance that it is not different this time. The reckoning will come, but later than most people expect. As Morgan Stanley says, "it will all end in tears, eventually, probably when higher inflation and rates lead to the next recession".

Before that happens, however, the market could very easily go through a period of euphoric self-delusion, which will suck in all the wrong-footed bears who are enjoying their moment in the sun before collapsing in the usual orgy of recriminations. Bull markets do not die of old age.

Superimpose a chart of the world's emerging markets from 2003 on one of America's Nasdaq market from 1994, as Morgan Stanley has done, and the trajectory is remarkably similar. If the one were to follow the other from now on, we would see lift-off, left up the page and close to vertical for a year or so.

No one will need reminding what followed the last explosive rise and Morgan Stanley is realistic about the consequences of recession. Equities could fall by 50pc or more as profits collapse and ratings overshoot to the bargain basement levels with which severe bear markets usually end. It just doesn't think we're there yet.

Morgan Stanley's anti-consensus call looks plausible, if bold in the current market mood. The building blocks are in place for one more leg of the bull market. Valuations are moderate, sentiment is terrible and, with inflation still only a background worry, the politically influenced Fed is in a position to do what it can in this pre-election year to ensure that the social costs of the housing fallout are minimised.

When that happens, the paralysing fog of contradictory signals could clear and investors will be free to latch onto the new "story" of emerging market growth. Missing out on the final burst could be an expensive mistake.