Friday, June 23, 2006

Short view By Philip Coggan - Finantial Times

Short view By Philip Coggan
Copyright The Financial Times Limited 2006
Published: June 23 2006 03:00 | Last updated: June 23 2006 03:00

Andrew Smithers is a noted bear whose 2000 book, "Valuing Wall Street" (written with Stephen Wright), was neatly timed to catch the top of the bull market. Although he was proved partly right (the high ratio of share prices to the replacement cost of net assets, the Q ratio, did herald a fall), Q has yet to revert to the mean.

His latest report on the markets, "Where we are now", is gloomy about the medium term. "Asset prices are out of line with incomes; in the absence of a marked rise in inflation, a return to equilibrium requires a fall in nominal asset prices."

While he forecasts gruel tomorrow, he is not serving it today. "We do not expect an immediate collapse in stock markets," he says, adding "so long as credit spreads remain low and managements are optimistic about profits, company buying should moderate market weakness".

This source of support cannot last forever, Smithers warns. Profit margins are high, particularly in the financial sector, and they have a strong tendency to be mean-reverting. The OECD's forecasts for 2007 imply a small fall in corporate profits as a proportion of GDP.

This creates some risky outcomes. The world economy needs to slow to counter inflationary pressures. But there is a likelihood of adverse shocks because of low savings in the US and the UK and large current account imbalances. As savings rise to a more normal level, the economy will slow.

"Below-trend growth is likely to be accompanied by falling profits," says Smithers. "As equity markets are seriously over-valued, there is a large risk that falling profits will cause a vicious circle in which falling profits cause further declines in the stock market, which will in turn increase household savings, partly through requiring higher pension contributions from companies, which will set off further falls in profits and share prices."

It is a strong bearish case. But bulls would sayprofits can stay high, because the global economy has moved in favour of the corporate sector, and the imbalances are not as unsustainable as he believes. Indeed, they have already been sustained for a long time.


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