Down from the clouds MONEY
NICHOLAS DAVENPORT
Since I protested against the absurdly high level of equity shares on the London stock exchange three weeks ago there has been a useful correc- tion—the Financial Times index falling thirty- three points in ten days from its-high of 522. The subsequent indecisive behaviour of the market suggests there.is a further correction to come. The old fires of the 'bull' market have gone out. Since the IMF meeting the market can no longer look forward to a writing-up of-the price of gold or, since the Basle agreement, to another devaluation of sterling in the.. fore- seeable future. It can depend only for its steam on a further depreciation in the value of money —and that only in the event of the roc finally repudiating the economic strategy of its own government. Which, of course, is possible.
Inflation has been the driving force behind the persistent demand for equity shares. It is-\ simply that the average investor, having loSt all confidence in the stable value of money, feels driven to buy the shares of companies which
70 promise to put more pounds in his pocket to off- set the decline in their purchasing power. The fear of inflation has also been driving up the prices of equity shares on Wall Street. Because President Johnson long disguised the real cost of the Vietnam war and delayed asking the nation to finance it in an honest-money way prices are now rising and the inflation idea gripping the whole country. It is significant that the recent upsurge in that market with a heavy volume of trading showed signs of a dangerouS inflation fever. But this is not likely to continue very long. A victory for Nixon in the presiden- tial election will mean—in the Republican View —a return to more honest money, a squeeiini of the money supply, a cutting of government expenditure, perhaps the end of the Vietnam war. It is strange that the old outmoded tactic-of squeezing money-supply is becoming fashion- able talk again in the United States as it is,here. It may be that a real slump in equity share prices will have to wait in Wall Street upon the return of a Republican government just as it may have to wait here upon the return of a Conservative government—with or without Mr Enoch Powell as Chancellor. The conservative parties on either side of the Atlantic protest their desire for honest money and for balanc- ing books. If they ever have the chance to do so, the simultaneous elimination of the deficit on the American and British payments balances Would cause quite a slump in world trade.
There is a technical reason for expecting a further correction in Throgmorton Street. The acute shortage of shares which has been driving up the prices of the 'blue chips' or the 'growth' equities is gradually being eliminated by the increase in 'rights' issues. In the first nine months of this year equity share issues have reached £254 million which is at an annual rate of £337 million against only £74 million in 1967. If this goes on there will be more than enough shares on tap to meet the demand of the unit trusts which have been growing at the rate of over £200 million a year. If it is thought that the incursion of the life assurance com- Panies into the unit trust business will bring on another shortage of shares in the market I would
beg to differ. The more equities are bought by unit trusts controlled by the life institutions the less will be bought by these institutions them- selves in their own portfolios.
This incursion into unit trusts was not done out of any love for-equity shares: it was forced upon the life companies by the competition from unit trusts in equity-linked life policies. In fact, the life fund managers have been greatly disturbed by the boom in equity shares which has brought down equity income and up- set the internal bookkeeping for their conven- tional 'with-profits' policies and their bonuses. You will appreciate that the unit trust throws the risk of the market on to the buyer of units and it is probable that the life fund managers welcomed this as an escape from the problem of their internal 'bonus' valuations. I would not, however, be surprised to find. that as the new unit trusts of the life companies are in- evitably slow starters the net effect of this in- cursion may be a net decline in the total demand for equities from the life institutions.
It is always difficult to gauge the amount of correction necessary to bring equity share prices down to a buying kveL The Stock Exchange is busily and 'properly discounting the increase in company profits which have been mounting since devaluation. Apart from the direct gains of the exporters and companies with large over- seas interests, the companies at home have im- proved their competitive position sharply against foreign rivals, have enjoyed an imme- diate rise in prices and have offset the rise in wages by an increase in productivity. The pro- fits of industrial companies published in Sep- tembet staged a rise of over 20 .per cent which followed upon gains of 13.7 per cent and 14.4 per cent respectively in August and July. The overall rise in industrial -company profits in the third quarter of the year was 15.8 per cent which was nearly double the increase reported in the first, half of the year. In 1967 there was virtually no rise in industrial profits. So one can imagine an average rise this year of over 20 per cent. On the Financial Times index of 496 the average earnings yield on an industrial share is now 4.7 per cent which is equivalent to a price/ earnings ratio of just over 21. Some of the active `growth' shares are valued on a price/earnings ratio of 30 or more. These are patently too high. But if these growth companies can produce increases in profits ranging from 20 per cent upwards, then the price/earnings ratios would be brought down to a reasonable 'buy- ing' level. Even so, the price/earnings ratio of the average Wall Street industrial share is
around 18 and if that fell to 15 British equities would still look comparatively dear.
It is a curious fact that whenever a boom in Wall Street pushes up the price/earnings ratios to 20 or more the market is considered vulnerable. At around a price/earnings ratio of 15 it is considered to be reasonably cheap. It is only the present dollar premium of 364 per cent which makes it possible to bring the two markets into line. But when Throg- morton Street brings the ratios down nearer to the American level, we may begin to consider that the market correction has been enough.
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