After the persistent weakness of the summer months culminating in sharp sell offs in September, share prices throughout the world bounced back sharply last month. Most stock markets have now risen by over 10 per cent from the low points hit in early October. What lies behind this rapid switchback to a much more benign share market environment?
A number of factors are behind the shift in investor perceptions. By far the most significant change was the dramatic shift in the attitudes of central banks throughout the world. For the past 20 years inflation has been the central bank governors' number one enemy. Despite the huge gains in reducing inflation over the years, central bankers seemed to be continually worried about even the prospect of slightly higher inflation.
The financial and economic turmoil of the past six months which has created fears of a contagious credit crunch throughout the globe, has caused a sharp about-turn in the policy stance of central banks. Fears about inflation have been relegated and the main risk to the health of the global economy is now deflation and the associated risk of a recession some time next year. The clearest manifestation of this was the two quarter-point cuts in short-term interest rates engineered by the US Federal Reserve.
The positive impact on share prices of lower short-term interest rates was further reinforced by the concerted response of the Group of Seven (G7) leading industrialised economies. The International Monetary Fund is getting increased resources to provide emergency support to economies which may become subject to unwarranted attack from financial speculators. Policymakers are also discussing ways to make the activities of hedge funds subject to more stringent disclosure requirements. The collapse of the large US hedge fund Long Term Capital Management (LTCM) highlighted the huge exposures which some of these hedge funds had built up and the risks they posed to the entire financial system.
The decisive actions of the world's leading central bankers and politicians to stabilise the global financial system was undoubtedly the most important factor in stimulating October's share price recovery. The million dollar question now is whether the worst is past and whether shares can resume their steady upward trend. Although the risk of an outright recession has been dissipated, a growth slowdown during 1999 is almost certain. This will result in very slow corporate profits growth with many companies not living up to optimistic earnings forecasts. However, with investment analysts busily downgrading their expectations regarding profit growth, it is likely that lower earnings are already reflected in current share prices.
A glance at the table which sets out the valuations of a selection of leading Irish and British companies shows many shares are now offering very good long-term value. This is particularly so when one compares the returns on offer from alternative investments such as government bonds and bank deposits.
The Irish market now stands out as being quite lowly-rated relative to other markets and relative to its own history. For example, the average price-earnings ratio of the Irish market over the past 10 years was 14.5 which is just in line with the average P/E for 1998. With the Irish economy maintaining its strong rate of growth, rising Irish corporate profits should enable share prices to move higher.
British shares are not offering quite the same value as Irish shares in an historical context. In the British market, the 10-year average P/E is 15.5 compared with a significantly higher 1998 P/E average of 18.5.
However, it is when the prospective returns from shares are compared with low interest rates that the argument for investing in shares becomes compelling. The more stable financial climate created by the decisive action from policymakers, combined with lower short-term interest rates, is likely to result in a favourable stock-market outlook over the next six months.
