Tough times ahead for 2006

Only a few weeks ago it looked as if the game was up as markets around the world plummeted. Now, however, the bulls are back in charge.

Only a few weeks ago it looked as if the game was up as markets around the world plummeted. Now, however, the bulls are back in charge. This week the FTSE and the S&P 500 hit four-year highs, European markets returned to levels last seen three and a half years ago, and even Japan's Nikkei served up a five-year high. So what's going on?

It seems that the market has recovered from the inflation scare that held things up earlier in the year. Now that the oil price has come off a bit, investors are once again convinced that low interest rates are here to stay for a while. The low interest rate environment has in turn been driving a spate of takeovers in the equity markets, which has put a floor under stock prices and injected more money into the markets to chase the limited amount of equities left. At the same time, there has been good news on economic growth from China (which has driven commodity prices and hence the prices of mining stocks up yet further), the Eurozone and the US. Add it all up and on the face of it there seems to be every reason for the good times to keep rolling.

But look a little closer and there is room for caution. Equities aren't expensive at the moment. The UK market is on a p/e of 14.5 times, Europe is on a mere 12.5 times, and the S&P on 19 times, which is hardly far off the level we saw in the 1990s. But are the profits that keep these ratios so low sustainable? Right now, in the US, corporate profits are higher as a percentage of GDP than at any time since the 1960s, says Philip Coggan in the FT. They can't go much higher, but they can go a lot lower, particularly if the US housing bubble bursts. In the UK, profit warnings are already rising fast, with any companies doing business related to consumption being hardest hit.

Then look at the takeovers driving large sections of the market higher. It should not be taken as a given that rates will stay low, and nor will the private-equity players doing much of the buying keep doing so if the market gets much more expensive. And if profits start falling, so will the corporate cash flows that look so very good at the moment. It's all very well to celebrate the progress of 2005, says Hamish McRae in The Independent on Sunday, but "we should all acknowledge that 2006 may be more difficult".

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