By LEIGH ROBERTS

FEW fund managers are prepared to stick their necks out and openly say they expect a correction on Wall Street, the world's biggest stock market.

This week Bruce Johnstone, managing director of Fidelity Investments – Boston, the largest asset management house in the world, aired his views on the state of the market.

The US stock market exerts a strong directional influence on most of the world's markets, including the Johannesburg Stock Exchange.

Johnstone was in South Africa to participate in an offshore investment conference hosted by TriStar International Consulting Limited.

Johnstone backed up his controversial views with an analysis of the fundamentals of a "decent" stock market.

Any decent market, he says, rests on three pillars: a benign inflation and interest rate environment; rising corporate earnings; and reasonable share valuations.

"In the US market, two of these three pillars have cracks in them," said Johnstone.

Inflation/interest

It is this pillar which Johnstone views as the strongest. The current environment of slow economic growth in the world will continue, he said, making it difficult for companies to raise prices, which leads to a lower inflation scenario.

Lower inflation means people who lend money do not charge as much, which begets a benign interest rate environment - and this has always been good for the stock market.

"And if you have low inflation and low interest rates, you always get high PE ratios on shares." (A PE ratio is a measure of how expensive a share is relative to its earnings.)

Corporate earnings

Corporate earnings have been very strong in the US, despite the economy experiencing one of the weakest recoveries on record. The reason for the earnings boost, said Johnstone, comes from huge increases in productivity afforded by technology.

"Corporate America is now lean and mean. Take IBM for example, who laid off 135 000 workers, a significant portion of their workforce."

But while things look rosy, cracks are developing, said Johnstone.

The strengthening of the US dollar against other currencies will make US exports more expensive. In recent years, exports have boomed because the US dollar has been relatively cheap, said Johnstone.

US companies who export will also feel the impact of the sluggish world economy. The high real interest rates in the US (about 4%) are a hardship to companies who borrow. And corporate profit margins, adds Johnstone, are currently at an unsustainably high level (about 6%).

Share valuations

Johnstone's view is that the current market is a speculative one - the market is narrow with investors speculating on large cap stocks. The high returns in the past few years have been restricted to large cap stocks and not the whole market.

Share valuations are now close to those of 1987 (the biggest one-day fall in the US market) and of 1929 (the worst bear market). "Current dividend yields have never been as low in the history of the US market. PE ratios have been exceeded only a couple of times, notably in 1987 and in 1929."

Johnstone said that the US Federal Reserve is also concerned about current valuation levels. The Fed has its own stock market valuation model - a ratio of the S&P 500 index divided by the ten-year bond yield - which shows that the market is approaching the ratio achieved just before that of the 1987 fall.

The US market, said Johnstone, is long overdue for a correction - there hasn't been a correction (defined as a 10% fall) in seven years, nor has there been a bear market (defined as a 20% fall) since 1987.

So, in the face of this bad news, what should an investor do? Johnstone's advice is to go for bottom-up investing, that is stock picking; diversify your assets and include bonds; avoid market timing.

Investors should remember that history shows the US market has gone up for two thirds of the time, and down for only one third. In this century the average annual market return is a healthy 10.5%.