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Daily Telegraph: Diary of a private investor

EXTRACT: My latest thought, which smacks of desperation, is to buy into one of the oil giants, like Royal Dutch Shell. If the IEA is right, and the oil market is going to remain tight for the next five years and perhaps longer, then, even after its strong rally, Shell at a price of only 11 times forecast earnings per share is not bad value at all.

THE ARTICLE

Last Updated: 12:01am BST 14/07/2007

‘Climate change’ fails to register, says James Bartholomew

This is a curious time in the stock market. The background for shares keeps getting worse, yet the market continues a fairly steady rise. It is reminiscent of those old cartoons in which a character runs off the edge of a mountain and keeps on running on thin air until, eventually, he looks down and realises there is nothing supporting him. Only then does he fall.

It is not quite as bad as that but the market has taken two pretty serious knocks without seeming to notice. First there is the rise in interest rates. Looking back to a year ago, the base rate then was 4.5 per cent . Now it is up at 5.75 per cent . The change in long-term interest rates is almost as big. The average yield to redemption of 10-year government bonds a year ago was 4.7 per cent . Now it has jumped to 5.6 per cent .

This should have been bad for shares. Companies have to face higher borrowing costs. Meanwhile, investors can see higher, risk-free returns on government bonds and should, in theory anyway, think more about buying these safe bonds instead of shares. Yet shares have continued blithely rising by more than a tenth during the past 12 months.

The second blow has been oil prices. They started going down but recently they have bounced back up again. This week the International Energy Agency said that the market would continue to be very tight for the next five years. Demand is expected to keep rising while supply struggles to keep up. I am having to re-think my cheerful view that the rise in oil prices would be reversed soon.

So companies and individuals will have to keep on devoting a higher proportion of their income to paying for oil and will have less money for profits and investment. And government will have to keep interest rates high to stop inflation getting hold.

Shares have therefore suffered a “climate change”. Yet the stock market has carried on with the same lifestyle as before. What are we to make of it? Are shares living on borrowed time or doesn’t all this stuff about interest rates and oil prices really matter after all?

My view is neither of these. I see it like this: interest rates do profoundly affect share prices but not in a strict, mechanical sort of way. If interest rates were to be raised a great deal further – say to 10 per cent – then shares would certainly fall. And if interest rates fell dramatically – say to 2 per cent – then shares would definitely rise. But, in between, there is scope for shares to behave a little independently of interest rates.

However, there is still a real consequence for share investors in the rise in interest rates. It is that the scope for a rise in the stock market is now less than it would otherwise have been. It remains conceivable that shares could rise by a fifth in the next 12 months. But it has become unlikely unless the rise in interest rates is reversed. Meanwhile the chances of, say, a 10 per cent fall in the market have increased. In other words, the rise in interest rates does not tell us what is about to happen in the stock market, but it has reduced the chance of a strong rise and increased the risk of a fall.

What then is the right strategy? A certain amount of caution, I suppose. For myself, I currently have a far bigger proportion of cash in my two portfolios than for most of the past four years. Not that the cash is evenly spread between them. My portfolio of shares in the Alternative Investment Market (Aim) is fully invested. These shares are all held in my self-invested personal pension which is allowed to hold Aim shares. But my other, bigger portfolio is comprised of Personal Equity Plans (Peps), which is not allowed to invest in Aim stocks. I am finding it much more difficult to find non-Aim shares that are excitingly good value. So this is 16 per cent in cash.

My latest thought, which smacks of desperation, is to buy into one of the oil giants, like Royal Dutch Shell. If the IEA is right, and the oil market is going to remain tight for the next five years and perhaps longer, then, even after its strong rally, Shell at a price of only 11 times forecast earnings per share is not bad value at all.

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/07/14/cmjames14.xml

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