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27 November 1998

Up, down, shake it all about

Is our money in the hands of lunatics? There was supposed to be a world crash; now the stock markets

By Phil Collins

There is no five-year period this century when the stock market has not gone up. The FTSE-100 index finished 1987 higher than it started, crashing in time to recover by Christmas. Usually stock markets are like building a house. A very dull, brick by brick, process on the way up but fantastically spectacular on the way down. At the moment we seem to be running the film backwards, and houses are springing up, fully formed, from the rubble.

During the summer months, the UK stock market fell 20 per cent. At the time this was described as a “correction”, as though the day before it happened everybody secretly knew the market was wrong. The Asian economies were in financial crisis, followed soon by Russia and then Brazil. Meanwhile, every economist in the City knew that the UK economic cycle was starting its descent. The summer of 1998 was not a crash, but it was plausible to suggest there was something right about it.

But now markets are going wrong again. FTSE has virtually retraced its steps back to the summit, near 6,000. There has been a 6 per cent rise in the past month alone and 13.9 per cent so far this year. The Dow Jones Industrial Average in the US has gone up 18.5 per cent this year and nearly 11 per cent this month, back to a record high. The German DAX has beaten both, rising 12.8 per cent this month and 26.8 per cent this calendar year. This is now the most volatile year on record in equity markets.

It is very easy, and sounds extremely sophisticated, to ascribe the rally to technical factors. There are derivatives transactions of such mind-bending complexity that no single person in the world actually understands them. Every other day we hear rumours of some vast hedging trade unwinding in markets we hadn’t even heard of.

A less convoluted technical factor is the level of liquidity in the market. Investment managers in the UK usually hold 4 per cent of their portfolio in cash. At the moment, they have nearly 11 per cent. They have to do something with the money and, short of keeping it in a tin in the office, it will chase the market back up again after every fall.

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And yet it is deeply perplexing, all the same. For technical factors, read “not really sure”. Stock markets can only operate briefly in a land through the looking-glass. A stock price is a summary of all the information currently available. In a market that is over-manned (sic) with people digging out information, prices are quickly corrected.

So there must be something rational about it. It is tempting to ascribe the rise to madness on the part of investors, though describing one’s clients as insane is a poor piece of marketing on my part. Besides, if the market was full of mad people the level would quickly adjust to discount it. You don’t need to be mad to work there, but it doesn’t matter if you are. Financial markets have an invisible mind that is rational, even if you aren’t.

There is more to be said for blaming stockbrokers, the reserve research army of the market. Last week the Chancellor of the Exchequer, no pessimist he, revised down his forecast for GDP for 1999 to 1 per cent. The average of all the forecasts in the City is for corporate earnings growth in the same year of 9 per cent. Nobody believes it. It is as though there were a peculiar smell in the room, obvious to everyone but so fetid that nobody will raise a hand to say: “Yes, I admit it, that was me.”

It is worth dwelling for a moment on why the forecasts should be so inaccurate because it tells us something about the nature of working in a market and why we can live briefly on the wrong side of the looking-glass.

There is no shortage of intelligence. If traders are the cavaliers of the market, then analysts are its pointy-heads. They are very clever indeed, but their numbers are consistently nonsense. This is in the nature of the job. Once, phrenology held a respected place in the academy; the practice of feeling the human skull was reputed to have predictive power. But phrenology soon passed into desuetude, replaced by more sophisticated soothsayers such as gypsies with crystal balls on the ends of piers. The stock- broker stands next in line, with conspicuously less success, as our failure to predict the Asian crisis amply demonstrates.

It is difficult to imagine any other profession in which people getting things so consistently wrong should be taken so seriously and rewarded so handsomely. If company analysts are supposed to get the forecast right, then they are catastrophically bad at their jobs.

But getting the forecast right is not part of the job. The City is not an academy and an analyst is not a disinterested seeker after truth. He is not Socrates weighing the contributions of Glaucon, Adeimantus and Thrasymachus and coming to a judicious conclusion. He is a man who is trying to generate business in a stock or win a corporate mandate. It is the difference between prophets and profits.

At every bank in the City, this produces a glut of recommendations to buy because that generates more commission. It is a rare investment bank that recommends selling more than ten of the FTSE 100 companies. Yet 48 FTSE companies have performed worse than the market over the past 12 months.

The forecasts are certainly inaccurate, but that begs the question of why anyone should want to believe them. Every stock market rally contains an article of faith and this is always the interesting part. The current article of faith is called the new paradigm. All over the City people are warmly embracing the new paradigm without ever realising that there used to be an old one. Hegel thought that the Battle of Jena in 1812 was the final synthesis. The stock market investors think that the defeat of inflation marks the end of normal history.

Hereafter, they say, equity investment is worth more than it used to be because it supplies a return in excess of inflation. The companies who merit a higher price are those whose earnings have leapt through a combination of organic growth and a huge round of corporate mergers. Every corporation in the land hates competition, for obvious reasons. As we stampede towards monopoly in every major industry, the value attaching to the leaders grows. Vodafone, for example, has gone up 101 per cent more than the market since January.

Implicit in the level of the FTSE is a faith that the new paradigm can continue in perpetuity. All the mathematical vanity reduces to the question of where we stand on the end of history. For the moment the market has talked itself better, like a form of therapy. It may well be that the developed economies have entered a new era. The only honest conclusion, but one that gives the game away, is to say that we don’t really know. Or technical factors, as I prefer to say.

The writer is an equity strategist with Dresdner Kleinwort Benson