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How High can the Share Market go?

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The Australian market, while it has basically echoed the fortunes of the US market, has been a bit of a laggard. But if a crash does occur in the US then no-one doubts that the effects will be felt here - and painfully.

The share market has always followed a cycle that is closely linked to the economic cycle and hence company profits. But in the short term markets can over (and under) shoot. Reality can then hit with an alarming thump. Usually a full cycle will last about five years from start to finish. However the current cycle, partly because inflation has been kept under control, has been in one basic upwards direction for eight years. This is practically unprecedented. In that time share prices in the US have more than trebled (see chart). It is no wonder that so many small US investors have been seeing the market as an easy way to wealth.

These investors see any downturn as a great buying opportunity instead of a reason to panic - so far. The key to the long term future of our market lies of course is the health of the US and to a large extent the Japanese economies. By most measures the US economy is in great shape - low inflation, low unemployment, a budget surplus and high growth.

But on the negative side the US trade deficit is growing alarmingly and the first effects of the Asian crisis are affecting company profits. The real worry is the Japanese economy which by all accounts is burdened with trillions of dollars of bad debts. If not managed properly Japan could send share markets reeling and the world economy into recession. But even if Japan clings on, the US market still looks vulnerable. It may be a case of famous last words, but we have here all the signs of a bubble about to explode.

History gives us a few bubble indicators.

1. Share prices rise out of all proportion to the expected gains in company profits.
2. Company mergers reach fever pitch.
3. Speculation in untested companies becomes rampant. Investors buy because they think the share price will rise not because the shares are good value based on expected earnings.
4. Property prices start to take off.
5. Inexperienced investors who know nothing about the share market become enthusiastic - the bell-hop syndrome.
6. The weight of money argument is dragged out to explain why shares will continue to go higher.
7. Borrowings are at high levels.

Share prices of established companies have been rising despite signs that corporate profits are falling. Multi-billion dollar mergers are now commonplace. The US property market is starting to froth and the bell-hops are buying feverishly.

Private debt in the US is high, increasing the danger of a downturn. The weight of money argument is again

being trotted out. According to this theory, so much money is being placed in the market that share prices will continue to rise indefinitely (and for ever presumably). This money is coming from countless small US investors and Japan.

Speculation is near fever pitch in high technology stocks. For example, the internet bookseller Amazon has seen its share price rise tenfold in a year even though it has yet to make a profit. Yahoo, a web browser, makes a profit of only a few cents a share yet its share price has been as high as $US207 recently.

The problem for soothsayers is that each investment cycle is unique. A downturn will come, we just do not know when. But as history shows - all it takes is one small trigger. In October 1987

it was a 0.25 per cent rise in interest rates that tipped the balance. When this occurs greed transforms into fear overnight.

David Tomlinson

Finance Journalist