The significant rise in global stock markets over the last 12 months has resulted in many questions around whether a bull market is beginning and the recession is behind us. The fact that, over the last year, developed markets are up 24 percent in US dollars and emerging markets up over 60 percent in US dollars may lead to this conclusion.

But according to Allan Gray and its global asset management partner Orbis, the market is set to move sideways for many years.

Despite the considerable gains by stock markets around the world, most markets are still some 30 percent off their highs experienced in late 2007/early 2008. During this period, companies around the world experienced a collapse in earnings due to a combination of factors including falling consumer spending, commodity prices and asset prices.

Will expected earnings materialise?

"The recent rise in stock markets appears to imply a strong recovery in earnings is ahead. The big question is whether these earnings will materialise and, if they do, to what extent," says Mahesh Cooper, head of Orbis Servicing in South Africa and a director of Allan Gray.

If one looks at the technology bubble in 1999, investors were prepared to bid up prices of IT stocks to extraordinarily high levels despite these companies making little or no profits. This was based in anticipation of future earnings as a result of expected growth in demand for information technology. The correction that followed is well documented, with many IT stock prices falling over 80 percent when earnings simply failed to materialise and business models were proven to be unsustainable.

"Looking back at those companies that did actually survive the tech bubble, like Microsoft, it’s clear that the scope to grow their earnings was there but the price that investors were prepared to pay in 1999 was just too high," says Cooper. Microsoft was trading at a PE of 70 in 1999. This meant that post the crash many of these IT stock prices went nowhere for close to six years despite the subsequent growth in earnings.

Good news priced in well in advance

For example, the current PE of Microsoft is now around 14 and reflects the company’s earnings growth without resulting in share price appreciation, as the good news had been priced into the stock well in advance.

"This brings us to the current environment and the extent to which people are presently pricing in earnings growth of the average company. Ideally you don’t want to invest when good news is already reflected in the share price. It would be even more foolish to overpay for potential good news that might not materialise," according to Cooper.

It is important to look at the long term, sustainable earning prospects of a company when assessing what its intrinsic value is, he says, while not overpaying for this potential future earnings stream.

Low earnings relative to share price

"With the current low levels of companies’ earnings relative to their share prices, investors are obviously pricing in a distinct level of earnings growth going forward. Investors often tend to think of stock markets as either rising in anticipation of improving prospects and earnings, or falling, when they expect a poor near-term outlook for company profits.

"Given the recent sharp rise in stock market prices, we would not be surprised to see company earnings taking much longer to meet the levels that are being inferred by current share prices."

Article continues on page two...

Editor's note: Shares are extremely volatile over the short- to medium-term. However, in the long-term they are not and consistently outperform all other asset classes. Click here to learn more...

What will you regret? Advice to a reader who wants to know if he should accept the promotion he's been offered...

Shares: flat as a pancake Allan Gray on why the stock market is set to move sideways for many years...

Medical aid 101 A guide to medical schemes including guidance on choosing one and your rights according to law...