Bears may be in retreat but bulls are still shy

Investor/An insider's guide to the market: For much of the late 1990s the prevailing mood among equity investors was one of optimism after so many years of strong equity market returns. Conventional wisdom was that any phase of falling share prices would be short-lived and represented an opportunity to invest at bargain prices.

After many years of good returns by the late 1990s investors' perceptions of the inherent risks associated with equity investing had become dulled. Three years of successive declines in share prices in 2000, 2001 and 2002 have radically shaken investors' confidence.

The risk associated with stock market investing is now to the forefront of all discussions regarding investment policy and strategy.

A significant outcome of the experience of the past three years is that investors' expectations regarding future returns have now fallen very sharply.

The general consensus now seems to centre on a view that annual returns from most equity markets will at best average approximately 8 per cent. This compares with average annual returns in the 15-20 per cent range for much of the 1980s and 1990s.

With the yield on risk-free government bonds now barely over 4 per cent, such an outcome would be reasonable. However, the extra risk involved with equity investing, as measured by the volatility of stock market returns, can seem disproportionately high when set against these lower expected future returns.

Among the large institutional investors, such as insurance companies and pension funds, the response to these changed expectations has been to shift towards lower risk investment strategies.

Consequently, a much greater emphasis is now being placed on investing in bonds, both government and corporate, where returns are more secure.

The response among individual investors is reflected in a much greater demand for investment products that offer a capital guarantee.

As a result, tracker bonds that offer participation in equity market returns, together with a guarantee of a return of capital at the end of the term, are proving very popular and, in general, individual investors are shying away from higher risk pure equity- based investments.

The general gloom that now pervades the investment scene, particularly as it relates to company shares, is in danger of clouding investors' perceptions. In this regard, a glance at the accompanying table that shows returns from several stock market indices portrays a reasonably positive picture for 2003.

After a very shaky first quarter, share prices have now been rising steadily for the past few months. At home, the ISEQ Overall index is up 7.4 per cent which is better than the return of 3.6 per cent from the Eurobloc 100 and the 5.6 per cent achieved by the FTSE 100.

However, the strongest recovery has been in America where the S&P500 is up over 13 per cent and the technology-laden Nasdaq is up by over 23 per cent. In most years, investors would take satisfaction from such returns at close to halfway through the year.

That this is not occurring reflects just how steep the falls in share prices were over the past three years.For example, even after its recent recovery, the Nasdaq is still almost two-thirds below its all-time high and even the broadly based S&P500 is still over one-third below its peak price level.

The pain suffered by investors in European equities is even greater with many European markets still over 40 per cent below their respective all-time highs. The ISEQ Overall index has performed somewhat better than the European average but is still languishing at one-third below its all-time high.

Given this scale of decline in share prices, it is not surprising that investors' confidence in the markets is now at a very low ebb.

However, it is often said that share prices generally climb a 'wall of worry' and there is no doubt that there are currently plenty of economic, political and financial uncertainties to worry about. Nevertheless, among professional investors, there seems to be a growing view that the worst of the equity bear market is now behind us although few believe that a period of high returns is at hand.

A key reason for caution is that equities still look expensive when measured by their price-earnings ratios (PERs). The S&P500 trades at a PER of 20 while the Nasdaq is trading on a PER of 45. European markets are trading on lower multiples than this while the Irish market is valued on a reasonable looking PER of 12. If economies grow at sub-par rates of growth for several years, these PERs are simply too high and companies will be unable to grow their profits fast enough.

The good news for investors is that the three-year bear market could well be over.

The bad news is that unless the global economy can grow faster than currently expected, it could be quite some time before a new sustained bull market can become established.