David Tomlinson
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Last Modified 2/8/99
Strange things are happening in world financial markets as investors try to cope with what appears to be an almost unrivalled period of economic prosperity.
If the current period of economic expansion continues for another few months the western world will have experienced the longest period of continuous economic expansion in recent history. We have already broken the record for peace time expansion and now only the record associated with the Vietnam war remains standing.
This is despite the turmoil the world experienced last year as the global economy teetered on the edge of an abyss. In August last year, you may remember, the Asian crisis deepened significantly, Japan officially went into recession and the Russians defaulted on their debts.
Long Term Capital Management, a highly leveraged hedge fund with vast sums owing to some of the world's major banks nearly went belly-up. It was only the intervention of the US Federal Reserve chairman, Alan Greenspan, that prevented it from collapsing completely. Such a collapse could have sparked a crisis of confidence in the banking system and sent the world into a recession and possibly another depression.
We were close.
By comparison, this year looks positively benign so far at least. The Asian economies are recovering, Japan is apparently moving out of recession, the Russians have been forgotten, inflation remains low, share markets in many countries are at or near record highs and economic growth looks likely to continue just about everywhere.
But there are strange things happening. The share markets in the west, particularly in the United States, have had an unprecedented run. The best place to have had your money last year would have been in a portfolio of international shares weighted according to the size of each economy.
That international share markets performed well is not so unusual. What is unusual is that this is the third year running that they have out-performed all other investments. Normally the best investment sector see-saws between local shares, bonds, property and international shares.
Even a purely cash investment can sometimes outperform everything else as it did in 1994. But if you lump local and international shares together then the share market has been the best performing sector over the last five years ñ something that has not happened for decades. This makes a little suspect the claims by the investment professionals who argue that the best investment strategy is to diversify between different sorts of assets.
But we live in strange times and, the economists tell us, the business cycle is not yet dead. It won't always be this way they say.
What is a little more worrying is that bond market investors have a different view to share market investors of what lies ahead. The big risk factor is inflation now that the US economy is becoming stretched.
Interest rates in the bond market have been rising on expectations that inflation, although low at present, will start to rise. But the share market, which normally suffers when interest rates rise, has gone up taking the view that inflation is under control. This has led to the situation where by some measures the share market is 50 per cent overvalued in the US. In fact using the traditional price/earnings ratio as a measure, the US market is at record levels - never have shares been this expensive even during the boom of the 1920s. Back in 1995 the P/E ratio for the US share market was around 17. Today it around twice as much ñ implying shares are twice as expensive as they were back then.
According to forecasters Access Economics, the only way these prices can be justified is if profit growth is extraordinarily strong over the next year or so. Current forecasts of US corporate profits however are for only a small rise this year and a fall next year.
No-one is really expecting that the share market will crash by 50 per cent or so in the short to medium term but at some point the divergent opinions of bond and share market investors will have to converge.
In the meantime share investing remains risky. And as we saw last year, the unexpected can occur at any time.
David Tomlinson is a freelance journalist based on the Northern Rivers.
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