A taper without a tantrum is a pleasant surprise and there can in some ways be no clearer example of how effective markets can be when it comes to pricing in, or discounting, future events. After seven months’ earnest contemplation, bond and equity holders are taking in their stride the US Federal Reserve’s decision to trim its monthly monetary stimulus programme from $85 billion to $75 billion.

There are two good reasons for this. First, policy is still wildly accommodative. Second, outgoing Fed chairman Ben Bernanke is stressing how interest rates may not go up even once the US jobless rate hits the 6.5% target.

The combination of cheap money, anchored interest rates and depressed bond yields is a key factor in 2013’s stock market gains. It would take a brave person to argue the same recipe will prove any less palatable in 2014, despite the appearance of some warning signs, such as high margin debt, an epidemic of director stock disposals and some froth in the still-nascent initial public offering market. With the possible exception of the USA, none of the major equity arenas look richly valued. Real market accidents only occur when markets are on above-average multiples of above-trend earnings figures, as shown by the bear markets of 2001 to 2003 and 2007 to 2009. Such conditions are not in evidence, for the moment at least.

Back to normal

If the Fed proved truly able to take quantitative easing to zero by this time next year, that would be a great sign the economy is finally returning to normal. I confess to harbouring more than a few doubts, not least because of Japan’s experiences over the past two decades. Every time the Bank of Japan tried to withdraw from its QE and zero-interest rate policies the economy rolled over and deflation crept back, obliging the monetary authority to unleash yet another round of stimulus.

The trick, as with any investment, is to therefore work out what valuation is telling us. A lowly rating for markets will provide some downside protection in the event of anything unexpected, such as a fresh loss of economic momentum. A lofty one could exposure investors to risk, which can be defined as permanent loss of their cash in the event of a market tumble.

Remember that returns from stocks over any long period of time are derived from:

• the level of corporate profits and cashflow

• the multiple the market is prepared to pay to access these earnings and any derating or rerating along the way

• the dividend yield.

Know the numbers

Equity strategy boutique Mirabaud Securities eschews short-term profit forecasts for its valuation work and looks at trend earnings on a multi-decade view. According to its analysis, the UK has traded on an average 14.3 times trend earnings since 1971, during which period corporate earnings have grown by some 6% a year.

Armed with the trend rate of profits growth, average rating and prevailing dividend yield, it is possible to assess the implied 10-year return on offer using a helpful mechanism proposed by American hedge fund manager John Hussman in his ever-useful weekly blog. His calculation is as follows:

((earnings growth * (long-term PE/current PE)^(1/10) +dividend yield)) - 1

The result is expressed as a percentage and the implications for the major developed equity markets are shown in the table below, although to help you do the maths for yourself and use your own assumptions the workings for the UK are as follows:

((1.06 * (14.3/11.2^(1/10)) + 0.035) -1 ) = 12.1%

Intriguingly, that implied annual average 12.1% return is a smidgeon above the 11.2% trend run-rate generate by the FTSE All-Share since 1962. This suggests UK equities are reasonably valued and with interest rates near zero and 10-year Gilts offering less than 3% that still is likely to be good enough for most investors. The danger is Government and consumer debts hold profits growth below its long-term trend path and such soggy earnings momentum chips away at sentiment to erode the rating the market is willing to pay relative to a more buoyant history.

Merry Christmas

This is the last issue of Shares for 2013. Everyone on the team would like to thank you for your custom and support and may we all wish you a very Merry Christmas and Happy New Year. We shall return on 9 January.