Fickle market means 'bear' forecast could be right or very wrong

London Briefing:  Tony Dye was the UK fund management industry's most high-profile casualty of the equity boom and bust.

More accurately, he lost his job as boss of one of Britain's largest money managers, UBS-Philipps & Drew, following many years of forecasting a crash in share prices that failed to happen.

His departure from the giant fund manager was exquisitely timed, as these things often are, with the peak in the market coinciding almost exactly with the day he left.

It took three years for stocks to recover any kind of footing but Mr Dye quickly reinvented himself as a successful hedge fund manager.

There are several morals to this story. First, nobody likes a "bear" (a pessimist, in market jargon). Second, getting it right doesn't necessarily mean a thing in the looking-glass world of financial markets, particularly if being right with a major market call is preceded by a less successful track record. Being right eventually doesn't count.

Third, Tony Dye's subsequent career relaunch, which sees him cosily established in nice offices a stone's throw from the Bank of England, serves as a useful reminder to all those unemployed City types that there is life after investment banking.

Tony Dye is at it again. He is getting lots of publicity for again saying that shares are overvalued. In some cases, he seems to think that equities are as expensive as they were back in March 2000, the peak of the equity bubble. Mr Dye seems to believe that the UK (and other) equity markets are likely to emulate the Japanese experience and go down for a decade.

Could he be right? If so, why have UK stocks just risen by around 30 per cent since March of this year? Perhaps we are just seeing the bubble re-inflated.

It strikes me that Mr Dye could only be right if the UK economy also "does a Japan" and doesn't grow at all - or even contracts - over the next decade.

Once we strip away all of the nonsense talked and written about the valuation of company shares, we find that there are two, and only two, drivers of stock prices. Valuation depends on a company's growth prospects and something rather loosely termed as risk.

For equities, growth is (nearly) everything. That is why the stock market is sometimes described as simply a big opinion poll about the future. The more confident we are about profits growth, the higher the stock prices. And vice versa. That's it. Everything else (almost) is just noise.

I mentioned risk also as being important. The "equity risk premium" is one of those slippery concepts that have the peculiar quality of becoming harder to understand the more we think about it. For stock prices, what matters is the riskiness of equities relative to government bonds. Of course, all of this has launched a thousand PhDs and many more dodgy stockbroker circulars.

But the underlying logic is dead simple. For example, at the peak of the equity boom at the beginning of 2000 it was absolutely right for Tony Dye to point out that equities were priced for future growth rates in earnings that had never been seen historically and that stocks were being seen as riskless as government bonds. Clearly, this was a state of affairs that was to prove unsustainable but it had been true for a number of years, and Mr Dye had said so, which is why, presumably, he ultimately lost his job.

Could it all be true again? I doubt it. If we do the maths, using assumptions of modest growth and a historically normal risk premium, we find that the UK stock market looks to be within spitting distance of fair value. Those assumptions are important of course, but they do not look unreasonable.

Put another way, Mr Dye could be right if the UK economy doesn't deliver even relatively low rates of growth. Perhaps that is his forecast. He could be very wrong if we are all surprised and the UK economy embarks on a sustained period of robust growth.

Tony Dye found to his cost that the market can depart from our calculations of fair value for very long periods of time. Our job as savers, investors and fund managers is to be disciplined during these periods and stick to our guns. Such a strategy didn't do much for Tony Dye's career but I'll wager that he is not fretting about his pension fund. Don't get too excited about the stock market but don't lose too much sleep either.