Still cautious about equity comeback

Ground Floor: I was having an idle chat with a friend last week when the talk turned to equity markets. It's a long time since anyone has talked to me about equities without gritting their teeth and telling me that they're sure I'm happy to be out of that game (despite the fact that I always tell them it was bonds that did it for me!) but the conversation had a familiar ring to it.

Basically, it was that interest rates were too low, shares looked cheap and so my friend had dipped his toe back in the market again. The good news was that the toe-dipping had been successful and had yielded a profit for the first time in three years. When I arrived home after that conversation, there was a newsletter in my mailbox telling me that there was still value in the markets even if I hadn't yet taken the plunge and allocated a sizeable chunk of my portfolio back into equities. Looks like share-tipping might come into vogue once more.

Actually, things have been looking up for equity investors for some time now with Wall Street seeing 12-month highs. A lot of that performance, though, has been in the Nasdaq which had previously plummeted so spectacularly and which is, as everyone now knows, made up of the technology stocks that were loved and then hated in equal measure.

Year to date, the Nasdaq is up 33 per cent but the Dow is only up 12.5 per cent. And so, the story goes, the time is ripe for a bit of a bounce in traditional stocks again, the blue-chip ones that we're all supposed to have in the portfolio. The ones that got slammed for being out of fashion and then slammed again anyway, and continued to be sluggish performers because the world economy has been gloom-ridden for so long.

Certainly, there's more optimism about the US economy lately - and, of course, the entire world looks to the US to be the driver of all things economic. Productivity in the States is high, spending is up and the Federal Open Market Committee (FOMC) still has concerns that deflation is a possibility - even if not a likelihood at this point and so is keeping monetary policy fairly loose.

But consumer confidence continues to rise and consumer spending has also increased which has allayed some fears. One statistic that many analysts like is the increase of an annualised 7.5 per cent in computer and software equipment which indicates that some companies are gearing up again on the back of an expectation of more business.

The main worry is still that employment hasn't picked up more and that's why the FOMC isn't likely to tighten policy in the immediate future. For investors, though, the policy is benign. Credit is cheap, money is cheap and so they are beginning to endorse the Fed stance and the slow recovery by looking at equities again. Most of the companies which have performed well this year have been the smaller ones which are, perhaps, more nimble in their ability to ride the wave. The S&P Small Cap index is up 38 per cent since March whereas the S&P 500 is up 23 per cent. Either way, though, the rise has been impressive.

So eager is this sudden desire to invest in US assets that the euro/dollar rate has spun around again and traders are trying to decide whether this is a sustained move or whether it's only a temporary correction. There are a lot of factors that make people think that the dollar's rise might only be temporary - mainly the fact that unemployment is still over 6 per cent and that the balance of payments deficit is frighteningly high. In order to stop people eventually selling the dollar again, the economy will have to perform better than Europe or Japan and sustain that out-performance.

There's no question that the US has the best corporate infrastructure for such out-performance but not everyone is convinced that it will continue to attract the necessary currency inflows. At the moment I'm on the side of the dollar bears and think that we'll see it weaken again at least a couple more times.

And as far as equities go ... well, I'm certainly more optimistic but picking the right stock will be very important; it's not a question of a rising tide taking everything with it.

The reason I continue to be cautious is that (revisiting my bond roots) credit ratings in the States are still poor. Downgrades in corporate debt continue to outnumber upgrades and that's gone on for nearly two years.

Corporates, even strong names, are still looking at high levels of debt and profit margins which are not exactly robust. Lots of (mainly institutional) investors bought into corporate bonds during the 1990s and they've all seen the spread on those bonds widen against government paper, thus diluting the value of their investment. In the last quarter a measure of optimism has been generated because some of the paper which had been rated junk has been upgraded to investment quality, but that's not at the end of the market where you really want to see upgrades. Most investors would like to see the more stable corporates regaining the double or triple A status that they lost because that would indicate a broader-based recovery.

However, in the past six months both companies and investors face the future with a greater degree of confidence than before. Many of the bull market-only day traders have been so badly burned that they've retired to a log cabin in Montana to lick their wounds, leaving the upturn to be engineered by professional investors like the big fund managers and the major hedge funds. The more conservative of them have missed out on the big gains because they've gone, Warren Buffett style, for the value companies and, once again, it's been the techs that have been stars. Whether they have the ability to keep burning brightly is still the billion dollar question.