I have been struggling to make sense of the market in recent weeks. Some might say that is a mista...
I have been struggling to make sense of the market in recent weeks. Some might say that is a mistake: stop trying to rationalise it and get on with enjoying it.
But before I put clients' money at risk, I like to know why something is happening. So I have been asking myself these two questions: Do I think the overall market looks good value? And can I find attractive individual companies ?
I think the dividend yield is a good place to start. I am writing this on Friday 15 August and my FT today tells me the historic yield on the All-Share is 3.3%. How quickly will this grow? My guess is 4% a year, maybe 5% at a push. So my likely annual return on UK equities is somewhere between 7% and 8%.
Why only 4%-5% growth for dividends? Fund managers will always claim their companies will do better than that but it is a decent assumption for the whole market.
Dividends reflect profits, profits reflect economic growth and economic growth is not likely to exceed 5% in cash terms.
If you don't agree, argue against this: in cash terms, the UK economy has grown 5% a year on average for the past 10 years. Similar growth is likely going forward because the Bank of England targets 2% inflation and I am not aware that our population growth has suddenly jumped up or we are experiencing a productivity miracle.
The argument that UK companies' profits are partly derived from overseas does not wash either. Some of those overseas countries grow faster and some grow slower but, on aggregate, the picture does not change much.
And if you really do think the UK economy, and other big economies for that matter, will naturally grow faster than 5% a year, how long do you think we will have interest rates at 0%-4% in the developed world?
It is usually a positive sign for the market if one can find a good crop of individually attractive companies on decent valuations.
There are some that fit this bill but the problem I have is many lie in parts of the market that have lagged the rally. The tobacco companies spring to mind. If you believe the market, these are now worth less than they were at the end of May.
But has there really been any change to the attributes that underpinned distinctly above-average growth records from these companies? I don't believe so.
Vodafone is another example. Here is a company for which the valuation has changed little in the past six months despite consensus estimates for 2004 earnings being 20% higher.
Of course there has been an improvement in cyclical economic prospects and this will benefit some companies more than others. However, many of the recent stock market winners need dramatic earnings growth to justify current valuations.
They will all grow if the economy picks up, it is just not clear the growth will be dramatic. Hope and expectation only carry stock prices so far.
The economy is looking better.
Profits will begin to improve.
Investors continue to be optimistic.
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