LONDON: If history is anything to go by, one iron rule can be applied to the stock market at times of war: conflict is good for shares, but only once investors become convinced that they are on the winning side.

Take the example of the Korean War, which started in 1950. When it became clear that the West would have to go to the aid of South Korea to defend it from communist troops in the north, share prices fell in the US by 13 per cent, and to a slightly lesser extent in London.

The uncertainty surrounding the outcome of the Korean conflict may be instructive: there were real fears that hostilities could be a prelude to a third world war that would pit America and her allies against China and the Soviet Union.

An American dealer who now works at a large French bank in London remembers just how frightened people were at the time: “I can recollect my father sitting at the dinner table and fretting that he would be called up again and find himself in combat, just five years after the end of the Second World War.”

As with the current situation in Iraq, it was the fear that a regional war in Korea could spill into something bigger and more dangerous that spooked world markets.

And yet, after three weeks of tumbling prices, stocks rallied as it became clear that a third world war would be averted, and that the Korean conflict could be contained. Of course, there are major differences between Korea in the early 1950s and Iraq in 2003. Arguably, the backdrop today is better than it was half a century ago. There appears to be no danger of a military clash now between the world’s major powers, and there is only one superpower remaining, the United States.

Nevertheless, there is a lot of uncertainty about the implications of war with Iraq. And those uncertainties appear to be more deep-seated than at the time of the Gulf War. In October 1990 shares dived, but even before the bombing campaign began, stocks rallied as George Bush senior put together a coalition and allied troops began to pour into Saudi Arabia prior to the liberation of Kuwait. In contrast, there is no bounce currently, even as British and American troops head once more to the Gulf. Why not?

That’s a difficult one. No-one doubts that America can prevail against Saddam Hussein in a conventional military confrontation, but anxieties persist that allies could find themselves bogged down in a quagmire not dissimilar to Vietnam. And the big unknown is whether intervention in Iraq will trigger some ghastly terrorist attack on civilian targets (either by Al Qaeda or one instigated by Saddam himself).

But there are other factors which make it difficult to determine the future direction of share prices. There is no example in recent history when the bursting of a stock market bubble has so closely preceded the outbreak of war. And while the statisticians and military planners can spend forever poring over charts and maps, there is another problem being posed by financial analysts: forget about the prospect of war for a moment, and consider the possibility that the excesses of recent years have not fully unwound.

As our chart shows, the big advance in stock prices came about in the last quarter of the 20th century — but that period is unique and, possibly, the exception rather than the rule. Do we expect shares to be such fantastic investments in the future?

Of course, no one knows, but history does not work in favour of the ‘cult of the equity’. Analysts point out that if you look at the returns from shares over the past 200 years, the yield is no more than one per cent, once inflation has been taken into account.

That statistic makes chilling reading, but it should be remembered when private investors are asked to look at returns from shares over the past 20 or 30 years by financial advisers eager to drum up business.

Returns from the stock market can be as high or as low as people want, depending on the starting point. A graph that begins from 1900 will be very different from one that kicks off in 1919 — the years prior to, and during the First World War, were a dreadful period for equities.

But the question of valuation levels for share prices is one that refuses to go away. As has been pointed out time and time again, Wall Street is still overvalued when the conventional yardstick of the ratio between share prices and corporate earnings is applied.

London is much nearer its historic norm. Does that mean it is worth buying shares on this side of the pond? Possibly not: if you believe the US market needs to come down to London levels, the Dow Jones Industrial Average must fall by another 2,000 points, nearer 6,000 than the current 8,000. And the problem for London is that if Wall Street tumbles, the shock waves are bound to be felt around the world, as America is still the engine that drives global capitalism.

Of course, the situation will be far worse if war in the Middle East leads to a disruption of oil supplies — a development that would undoubtedly delay and jeopardize economic recovery.

As things stand, London share prices may look as if they represent reasonable value, but they are not exceptionally cheap. And canny investors will wait for two reasons: first to see how war with Iraq unfolds, and second to see whether markets plummet again — stock prices usually overcompensate on the way down, just as they overshoot when they head north.

Fund managers have already rejigged their portfolios in a way that reflects the new investment landscape, one in which shares are less important. As we reported in these pages last week, with-profits pension funds run by the country’s biggest insurers have dramatically reduced their exposure to equities — from 70 per cent in 2000, to just 35 per cent today.

Their portfolios are now more heavily weighted towards cash, property and fixed-interest securities such as government bonds. That is more in keeping with weightings that were considered typical before the 1960s.

While equities languish, precious metals such as gold have seen their value soar as investors seek a safe haven during uncertain times. Gold is trading at nearly $370 an ounce for the first time in more than six years, and experts believe it could hit $400 or more in the next few months. Platinum has hit US dollars 670 an ounce, its highest since September 1986, while the Swiss franc, traditionally seen as a safe bet, is approaching four-year highs against the greenback.

But for stock markets, there is little evidence to suggest that they will resume their bull run. A successful war against Iraq will doubtless produce a rally, but what happens further out is anyone’s guess.—Dawn/The Guardian News Service.