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Has the FTSE 100 rallied too far, too fast?
We should be glad the stock market is doing well but a 6% gain in January has got alarm bells ringing.
by Gavin Lumsden on Jan 25, 2013 at 16:57Follow @FundFanatic
Stock markets around the world have got off to a flying start to 2013. This includes the UK’s FTSE 100 which has soared more than 6% so far in January. Over six months the blue chip index has gained an impressive 15%.
After recent difficult years, it's a relief to see the FTSE 100 hurdle one ‘resistance’ point after another: first 6,000, then 6,100 and 6,200 have fallen this month. Even 6,300 looks in reach after another round of economic indicators this week pointed to recovery in the eurozone, US and China.
(In the event it wasn't as the index closed on 31 January at 6,277, a monthly gain of 6.4% or 379 points. See 'Does a good January mean a good year for the FTSE?' for more analysis.)
(cont) True, the UK economy is in the dog house, teetering on the edge of another recession with the news today that our gross domestic product (GDP) shrank by 0.3% in the last three months of 2012. But as today's Friday Five points out, many of the big FTSE 100 companies are global businesses, increasingly looking to the ‘emerging markets’ of Asia and Latin America for growth.
The good news is that when it comes to investing your ISA or pension you don’t need to worry about the UK economy quite so much. (Although it is totally pertinent when looking at the pound in your pocket, tax bill, job prospects, benefit cuts etc.)
Yet just as investors are finally enjoying ourselves, a party pooper pops up to tell us to stop being silly and put the drinks away.
I’m referring to Alistair Mundy (pictured), the long-standing fund manager of Investec Cautious Managed (and many other funds), who, appropriately enough, sounded a note of caution this week. Mundy urged investors to reflect on why they might be rushing into shares now, when they didn’t in 2009 when the FTSE 100 hit a low of 3,530 in March after the banking crisis?
Mundy is a ‘contrarian’ who likes to invest when others are afraid to. He wasn’t actually arguing against investing (which fund manager does?) but simply pointing out that with the FTSE 100 having risen so far there was more danger of it falling now than there was four years ago. The ‘downside’ is literally greater the higher you go.
Mundy isn’t against investing, he’s just not excited about the UK stock market, or the US for that matter, preferring countries like Japan and sectors like gold miners which are cheap. (Yes, strange but true gold is expensive but the companies that get the stuff out of the ground are good value.)
Are markets cheaper?
It’s good to diversify your investments outside the UK so I’m not arguing against Mundy. But there is a case to be made that piling into the FTSE 100 when it is back at levels last reached in 2000 and 2007 is not as mad as it may sound.
This may sound odd given that on both occasions the index crashed soon afterwards. However, Lars Kreckel, a global equity strategist at Legal & General Investment Management, makes the point that although stock markets have regained their levels of six and 13 years ago, they are in fact cheaper. This is because US corporate earnings, or profits, for example, have grown by 80% since 2000 and by 10% since 2007. Same price but more profits means the US S&P 500 is around half the price it was in 2000.
Of course, the important question is will companies continue to grow their profits like this? Many investors, like Mundy, think US companies won’t and so aren’t investing in the country very much. Others take the opposite view, saying a recovery in its housing market will feed through to the US consumer and thus into the rest of the economy, while an energy boom from cheap shale gas will allow US companies to maintain their profit margins.
Let’s put that debate to one side. The question is has the FTSE 100 rallied too far, too fast? Has the stock market got ahead of itself? The answer to that is yes, it probably has.
Evidence for this comes from a slightly unexpected source. Analysts at Bank of America Merrill Lynch have been arguing for some time that there could be a ‘great rotation’ this year as investors switch out of defensive, but expensive bonds into better value, higher yielding shares.
What we’ve witnessed in the recent stock market surge is proof that this is happening, that bullish investors are becoming more convinced that, generally speaking, the world is recovering from the financial crisis: that growth, rather than recession, is going to be the order of the day.
But the transition from hordes of investors buying bonds to hordes of investors buying shares is not going to be smooth, says BoA Merrill Lynch. Echoing Mundy, the bank’s investment team argues that a great leap forwards could be followed by a fall or ‘correction’ in the spring.
What happens to bonds
As I try to explain in this week’s Lolly Investor Programme (see video below), the key to what happens is in the bonds market. If there is going to be a global recovery followed by rising inflation and interest rates, bond prices will fall.
But this could be where things get tricky. When bond prices fall, their yields rise. Yields measure the amount of income a bond’s fixed rate of interest will deliver if you buy at the current price. Government bond yields are seen as a measure of what interest rates will be in the future. If it is thought that interest rates will rise, bond yields will rise first and therefore their prices will fall. We’ve seen a bit of this already this month.
BoA Merrill Lynch paints three scenarios.
1) The good
The best is that as in the early 1960s share prices and bond yields rise steadily. What investors lose on the bonds, they make up for on shares.
2) The bad
However, it warns there could be a repeat of 1994 when growing optimism about the US economy saw another big rotation from bonds into shares. Only then bonds crashed, dislocating financial markets so badly that share prices eventually fell too.
3) The just as bad
Less likely, it says, but equally alarming, there could be repeat of the Great Crash of 1987 when, among other things, equity markets took fright at the speed at which bond yields (which indicate the future cost of borrowing) were rising.
Obviously, the first scenario is much easier to contemplate. So while we should be glad that confidence has returned to stock markets, we should hope that a dash of wintry weather cools things down a little.
More about this:
Look up the funds
Look up the fund managers
More from us
- The Lolly survival guide to investing in bonds
- Bullish investors ignoring risks, warns £11bn fund manager
- Get ready for a 'Great Rotation' in stock markets
- ‘Triple dip’ alert as UK economy contracts again
- Friday Five: UK companies to profit from emerging markets
- FTSE heads for 6,300 as bulls take charge
- Does a great January mean a good year for the FTSE?
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