High equity weightings enabled pension funds to benefit from booming stock markets, but this is no longer the case

Over the past few weeks investors in stock markets have had to endure a further intensification in bear market conditions. Share prices have continued to react badly to any hint of fresh bad news and, significantly, daily trading volumes are frequently hitting record levels.

High trading volumes are significant because they indicate that a large number of sellers are prepared to sell stocks at current prices. Share prices in many stock markets are now back to the levels that they stood at five years ago. The fact that these prices are being reached with very heavy trading volumes can be interpreted either positively or negatively with respect to future trends.

The positive view is that this heavy trading at low prices represents the final capitulation of those investors that remained heavily committed to equities up until recently. On this interpretation, once this current bout of selling runs its course, there will be no more sellers left and share prices can then rise from a new base.

The alternative view is that these high volumes indicate that some of the large financial institutions have now begun to sell equities in a serious way and that they will continue to sell for a prolonged period. Those who subscribe to this bearish outlook point to a number of factors to support their case.

Firstly, pension funds in the US, Britain and the Republic hold a high proportion of their assets in equities. Equities typically represent 60 per cent to 80 per cent of pension portfolios in Britain and the Republic. Throughout the 1980s and 1990s, these high equity weightings enabled pension funds to benefit from booming stock markets. However, expectations regarding prospective equity returns have fallen and, therefore, pension fund trustees and advisers may well prefer to maintain much lower equity portfolio weightings in future years.

A more immediate serious concern is the fact that the decline in share prices to date means the present value of many pension fund liabilities is greater than the relevant assets at current market values.

A related problem has arisen amongst many insurance companies leading to a decline in their solvency ratios. The regulatory authorities in Britain have already relaxed their requirements regarding minimum solvency ratios in order to ensure that insurance companies don't become forced sellers of equities.

Unfortunately, since then equity prices have fallen even further and there is a suspicion that some of the recent stock market weakness has been due to some forced selling by pension funds and insurance companies.

Analysis of the accompanying table highlights that we are now unquestionably in the worst bear market since 1973-1974. Global equity markets are into a third consecutive year of decline. More worrying is the fact that the speed and extent of share price declines has accelerated sharply so far this year.

The bell-wether Standard & Poor's 500 has fallen by 26 per cent so far this year on top of declines of 12 per cent and 10 per cent in 2001 and 200 respectively. The British market, as measured by the FTSE 100, has fared just as badly.

The story for European markets is much the same. The FTSE Eurotop 300 index is down 25.8 per cent in the year-to-date following a decline of 20 per cent in 2001 and 1.5 per cent in 2000.

The Irish equity market fared much better than overseas markets in 2000 and 2001 but has joined the general malaise this year. Over the year-to-date, the ISEQ Overall index has fallen by 23.8 per cent, although the catastrophic fall in Elan accounts for a high proportion of this decline.

There seems little prospect of immediate relief for long-suffering equity investors except to cling on to the knowledge that, over most long-term periods, equities have been the best-performing investment asset. As long as the global economy achieves even moderate economic growth, then companies will be capable of growing their profits over the long term.

If inflation stays low, this real growth in profitability will eventually flow through to equity investors either by way of increased dividends or increased share prices. For those investors with a long enough time horizon, with cash to invest and possessing strong constitutions, the coming months may well through up some very attractive investment opportunities.