IT SEEMS bizarre that, in less than a year since Lehman Brothers pulled the plug that let the economic bathwater go down the drain, equity markets have recovered most of the losses suffered in the subsequent market meltdown.

Was it all just a bad dream?

It was certainly a nightmare to live through, both for those involved with financial markets and those affected by the wider economic consequences of the near-collapse of the banking system.

As with most economic crises, there was real substance behind the markets’ fears (excessive levels of leverage, bank loans exposed to overvalued property and imprudent funding policies) but events ran more than usually out of control. The situation was rendered unmanageable by the panic that ensued when banks tried to reduce exposure to Lehman Brothers and other banks perceived as vulnerable, leading to a collapse in the credit markets and doubts over the ability of many banks to remain afloat. The policy response to prevent what threatened to become an economic catastrophe was unprecedented in size (global interest rates were cut close to zero) and the degree of co-ordination.

It now appears that, having calmed the panic, these measures are at least up to the job of mitigating the recession and may have brought about a faster-than- expected resumption of growth. Nobody uses the “d” word any longer and the economies of Germany, France and Japan are no longer contracting.

There are good reasons why this is unlikely to evolve into a boom any time soon (at least for the developed economies, weighed down with private sector debt and gaping government deficits) but the outlook is considerably better than feared only a few months ago, and the trend is improving.

Equity markets have moved to reflect this and no longer trade at bargain basement ratings. Indeed, most of them trade at or above the valuations prevailing before the Lehman bankruptcy last September. Can this be right? The answer depends on whether the trend towards recovery continues (in which case time is on investors' side, as valuations are supported by rising earnings and dividends). This is what seems most likely, in which case it would be reasonable for equities to trade on higher ratings than those immediately preceding the crisis. The point at which the waterhole is most dangerous for the approaching wildlife is when its surface is undisturbed by ripples from predators. The unsuspecting are at greater risk of being eaten.

Once mayhem has broken out, it changes the game. So, investors can rationally pay more now for equities, cognisant of risks that were concealed a year ago and hoping that they are buying on the basis of trough earnings.

Of course, the risk remains that the more cyclical parts of the market, which have made most of the running, may still be patrolled by crocodiles.

There is considerable hope built into the prices of stocks dependent upon economic recovery, so the fulfilment of investor hopes will be alloyed with elements of disappointment. It may be safer seeking visible opportunities in the defensive shallows, than stampeding into deeper waters.

Andrew Bell,

Head of Research,

Rensburg Sheppards

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