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Causes for concern

It is difficult to find anyone whose optimism remains completely untrammeled at present.

The media, those I talk to – everyone appears to expect some form of market correction. Yet shares have proved remarkably robust. At least that is how they looked at the start of last week. The incidence of Easter has meant that I have to take the temperature of the investment community that much earlier than usual on this occasion. Moreover, this year, the Easter break coincided with the end of the tax year – traditionally the busiest time for anyone involved with managing or advising private investors.

This time last year, we did suffer from some not inconsiderable nervousness among investors, with the most damage being wrought in emerging markets. The subsequent recovery was impressive, though, and the problems that did emerge later in the year have largely been shrugged off.

It does rather feel as though investors’ appetite for risk has returned, which perhaps explains why the professional community is viewing the approach of May with increasing alarm. And there are some very genuine concerns to take on board. Aside from the considerable airtime devoted to the US housing market and the travails of those lending to the bottom end of the borrowing spectrum, there seems little doubt that economic growth is slowing.

The real concern is whether it will slow to the point that a recession ensues – not a fanciful notion, given the continuing concerns of the Fed over inflation. Further rate rises cannot be ruled out.

Then there is the valuation worry. One of the great supporting pillars of equity markets is that they are cheap, both historically and in comparison with bonds. This is arguably more true of the UK than elsewhere but how valid is this argument? It has been suggested to me that if you take away the top 10 stocks from the FTSE 100 index – which I might add is a very fair chunk of its overall value – then the price/earnings ratio rises from the present undemanding 12.5x to more like 16.

I confess I have not done the sums myself but looking at the ratings of such giants as the oil majors, the leading banks and even, remarkably, Vodafone once all the write-offs have been completed, you can see just how cheap some of the market leaders have become. Just as important is the fact that because these giants of the domestic stockmarket enjoy such undemanding ratings, the valuation applied to the rest of the index has been distorted as a consequence.

On the face of it, this situation appears to provide an opportunity rather than a threat. If you are, indeed, concerned over possible shockwaves travelling through shares, then some protection could be available through switching into the lowly rated giants. Except that this breaches two tenets of investing.

First, that diversification, even within an asset class, is not merely desirable, it is arguably essential if risk is to be properly managed. Such an approach would leave an investor vulnerable to the vagaries of, in particular, oil and the banks.

The second aspect of this approach which does not stand close inspection is the belief that lower rated shares will automatically fall less fast than those that are more expensive. They might, but the truth is that markets tend to be indiscriminate when the bears take hold and investors head for the hills.

Back in 1974, the likes of Shell were standing on a p/e multiple of three. If repeated today (which, heaven forbid, seems unlikely), then the price would have to drop by around two-thirds. Even so, markets do not move in straight lines, so preparing for some sort of setback makes sense to me.

Brian Tora (brian.tora@centaur.co.uk) is principal of the Tora Partnership.

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