Fourth year of decline is a distinct possibility

INVESTOR: By and large the 1980s and 1990s delivered a virtually uninterrupted series of strong annual investment returns. There were of course some difficult periods, most notably the 1987 stock market crash which saw share prices plummet by 30 per cent in a matter of days.

However, on a long-term chart the crash of 1987 is no more than a downward blip within a very strong and sustained up trend.

The duration and magnitude of the 1980s and 1990s bull market created an environment that encouraged ever-increasing investment flows into equities. Investment executives in their sales pitches for new business regularly wheeled out data from long-term historical studies, showing that equities outperformed other asset categories over most periods.

Now, after three years of back-to-back negative returns in most global equity markets these statistics have lost much of their previous shine. The cumulative decline in the US stock market since end-1999, as measured by the S&P 500 index, is now close to 40 per cent. In the UK the cumulative decline in the FTSE 100 is even worse at just over 40 per cent. The ISEQ overall index has done much better over the period with a cumulative decline of "only" 20 per cent.

Unfortunately, this ISEQ performance flatters to deceive, as the Irish market did not participate in the very bullish markets of 1999. In that year the Irish market fell by 2 per cent whereas European equity markets rose by approximately 30 per cent and the FTSE 100 rose by 18 per cent. Therefore, over the past four years the ISEQ has performed more or less in line with the UK market.

In a historical context the bear market that began at the start of the new millennium is now unquestionably an exceptional event. Looking at US data there has been no three-year period of successive equity market declines since World War II. The only comparable bear market over the past 55 years was that of 1973/74 which lasted for two years although the magnitude of the decline was greater, particularly in the UK market. During 1975 equity markets bounced back very sharply. In the US the S&P 500 rose by 30 per cent whilst the UK market rose in excess of 130 per cent.

What are the odds on an equity market bounce-back in 2003? A fourth year of negative returns would seem to be statistically highly unlikely. Nevertheless, it is very difficult to envisage a sharp early rebound in share prices.Growth across the global economy is weak and most of the risks seem to be on the downside. The US economy is expected to pick up in the first half of 2003 but this is predicated on continued strength in consumer demand. Growth forecasts for Europe have been slashed, reflected in the German economy that is now expected to stagnate in 2003. Japan remains mired in a long-term structural recession/deflation leaving China as the only real bright spot in the Far East.

The US and UK economies are almost totally reliant on continued buoyancy in consumer spending. Personal levels of indebtedness are at record highs in both economies and if the consumer suddenly stopped borrowing both would slide into recession. Short-term rates at 40-year lows mean that consumers can afford high levels of debt and therefore a sharp fall-off in consumer demand is unlikely. Nevertheless, it is salutary to realise that these very low interest rates are just barely staving off recession.

Indeed, further declines in interest rates are a distinct possibility during the first half of 2003. Recent statements from the ECB could be interpreted as leaving the door open for even lower euro rates.

From the viewpoint of investors the absence of inflation and exceptionally low interest rates is a positive feature. With returns so low on deposits and bonds investors may well be tempted back into equity investment.

However, there is a missing ingredient, which is growth in revenues and profits. Most businesses are finding it extremely difficult to grow their sales and profits and a meaningful improvement is unlikely in 2003. Without such growth it is difficult to see what will act as a catalyst to reinvigorate equity markets.

A favourable resolution to the Iraq arms crisis could act to boost investor sentiment. A rapid resumption in the growth of business investment spending plans is another area that could produce a positive surprise. However, after three years of negative "surprises" investors are in no mood to take anything on trust. A return to a sustained equity bull market requires a more vibrant global economy that may well only emerge in 2004 rather than 2003. Therefore, equity market prospects for 2003 are on a knife-edge and a fourth year of decline remains a distinct possibility. However, if a double-dip recession is avoided then share prices should move higher from coming levels to provide some much-needed respite to battered equity portfolios.