Play safe with the bears: Blue-chip shares are the best bet for investors while the market remains weak

THE signs are that the stock market is making a step adjustment - downwards.

When sterling crashed out of the European Monetary System in September 1992, a dramatic easing of monetary policy helped share prices take off. The equivalent but opposite action this time was the decision by Alan Greenspan, the Federal Reserve chairman, to raise US short-term interest rates by 0.25 per cent. The move has snowballed into what looks increasingly like a dramatic tightening of global monetary conditions. UK bond yields have risen nearly 40 per cent since the beginning of the year. By contrast, equity yields have only risen 21 per cent, part of the reason why shares remain under severe pressure.

My instinct at moments of pronounced stock market weakness is to advise buying blue-chip shares. They rarelygo bust and will typically hit new peaks in the next bull phase. The natural tendency for share prices is to rise, so periods of weakness are like stretching an elastic band - eventually prices will bounce back.

In the early years of the century, bear runs in stock markets were known as panics, carrying a clear implication of short sharp shocks. A great American speculator, Bernard Baruch, used to argue that investors should buy into these panics. Until 1929, this proved the right strategy.

But there is also a case for caution when share prices are falling sharply. Buying at such times has been likened to trying to catch a falling knife. It can be prudent to allow somebody else to make the first move.

There is a tendency for share prices to hit their low point for the year in the second half. This fits in with the sell-in- May and buy-in-December theories of stock market seasonality. A safety-first strategy for those with sufficient resources could be to buy some shares over the next few days but reserve further funds to buy again in October and December, ahead of what could be a much more positive stock market performance next year.

A particular difficulty for stock pickers at present is that the market is being driven almost entirely by trends in the global economy. Individual performance counts for almost nothing. For instance, the unit trust group Perpetual recently reported first- half profits had more than trebled and said second-half performance would be good even if the stock market stayed uncertain. The shares bounced briefly, but are already almost back to where they were before the figures were released. Yet there are signs of a sea-change in investor behaviour, with funds flowing strongly into unit trusts even when shares generally are not doing well. If that continues, the long-term prospects for such groups as Perpetual would be very good.

One way to try to evaluate the broad position is to look at the dividend yield. The median yield on the FT All-Share index over the last quarter-century has been around 5.5 per cent. Stock market peaks seem to occur when the yield falls to around 3 per cent, while above 6.5 per cent, shares are a screaming buy. On that basis, a yield approaching 4.5 per cent may not seem too enticing. But it already implies upside potential of around a third if yields reach 3 per cent again in the next bull cycle, on top of dividends rising at an annual rate of between 7 and 10 per cent.

What could signal the turning point? One rule of thumb is that shares are close to the turn when the number plumbing new lows exceeds those attaining new highs by a factor of 10 or more. That condition has been amply fulfilled nearly every day in the past week. A classic buy signal would be a high- volume sell-off. So far, shares have been falling on lack of buyers rather than heavy liquidation. This is not unusual. It is often said that shares can fall under their own weight but need real buying to push them higher. But if the sellers come in to produce a real panic with rising volumes, that should mean a turning- point is near. A third sign that often works is when stock market movements make headline news.

A fourth is evidence of real demoralisation, or what some strategists describe as investor capitulation. Most pundits are still talking of shares ending the year way above current levels, but views are changing.

Strategists at the stockbroker Nomura Securities have been among the most bearish since mid-February, but were still talking recently of the FT- SE 100 index ending the year at 3,500. Privately, they now say they expect it to be 2,700 to 2,800 with recovery coming later. If and when that view seems widespread, it will be time to buy.

For investors who feel there is a chance to have a go right now, I have some suggestions that also fit my blue-chip criterion. The 12 I would choose are Burmah Castrol at 868p, GKN at 583p, ICI at 819p, Johnson Matthey at 579p, Laporte at 751p, Lonrho at 141p, Next at 244p, Racal Electronic at 229p, RTZ at 817p, Shell at 706p, Smith & Nephew at 152.5p and Royal Bank of Scotland at 404p. The emphasis is on a mixture of special situations and producers of materials and commodities, which are likely to benefit from the global economic recovery.