The increasing globalisation of major stock markets, with foreigners holding nearly 30% of UK equities by value, has created a growing gap between the UK stock market and the British economy
At first sight, it is disappointing that the performance of the UK stock market this year has not mirrored the resilience of the British economy. This is scant reward for Britain's leading position in the growth league among G7 members.
The FTSE All-Share Index has closely tracked the S&P Composite so far this year (both have fallen 18%), although it has fared much better than other European equity indices. Much of this can be attributed to the increasing globalisation of major stock markets. Around half the profits of FTSE 100 Index constituents are derived from overseas, while foreigners hold nearly 30% of UK equities by value. Hence the distinction between Great Britain Plc and the UK stock market grows ever sharper.
As one of the most international leading stock markets, it is no surprise that global influences have been, and are likely to remain, paramount. So looking ahead, the fortunes of the US economy will play a key role in determining whether the recent low (on 21 September) in the fortunes of almost all equity markets was the end of the thirteen-month bear market or a staging point in a longer downturn.
In the aftermath of the terrorist attack on 11 September, the consensus view now is that a combination of low interest rates and a large rise in public spending will restore the pattern of growth to the US economy in the second half of 2002. If that happens, the corporate newsflow should improve and profits warnings should subside, to be replaced by earnings upgrades and improving visibility for the business outlook. Such an outcome would certainly create stability in financial markets and lay the foundations for a new equity bull market.
There is clearly a risk that this optimistic assessment, which is currently the consensus view, will not materialise in its expected form. The immediate economic outlook, further exacerbated by the disruptive impact of terrorist actions, is fairly bleak, with company profitability under pressure and the corporate newsflow gloomy. Market watchers are anticipating a turning point, but expectation is constantly being pushed further into the future. It is possible that the company reporting season covering the final quarter of 2001, beginning in January, may see fewer profits warnings, but this looks a little far-fetched given the unfavourable economic environment.
However, company managements are increasingly realistic about the problems they face and the accelerating pace of job cuts represents a solid attempt to tackle their cost base. This could mean that before restructuring charges, operating margins may be about to stabilise after months of decline, which, with slowing revenue growth, has fuelled the downgrading of profit forecasts.
The divergences between different stock market sectors have, arguably, been of far greater significance than the course of the main equity indices. Polarisation has reached extreme levels this year, with many technology, media and telecom stocks losing much of their value, while certain traditional sectors, like construction and general retailing, are higher in absolute terms. Furthermore, traditional valuation tools, like dividend yields, which went out of fashion during the technology boom, have made a comeback. With inflation down to 2.3%, coupled with falling returns on cash deposit accounts, good quality income stocks (those with well-covered dividends and prospects of future growth) look very attractive. It is even possible to build a portfolio of stocks yielding as much as government bonds, but care must be taken to avoid those where distributions may be under threat.
The key call in March 2000 was a switch out of the FTSE 350 Lower Yield Index into the FTSE 350 Higher Yield Index. Valuation differentials had reached levels that discounted continuing decline and unlimited growth for the latter.
However, despite the huge performance differential, the valuation guide looks too wide. The yield on the FTSE 350 High Yield (3.7%) is still 2.5 times that of the FTSE 350 Lower Yield, while the price/earnings ratio of 14.8 on the former still stands at less than half the level of the latter index.
Valuation premiums for growth stocks have been squeezed, leading to severe underperformance for most of them (pharmaceuticals excepted). A more business-friendly environment, with the associated decline in the level of the equity risk premium, would probably help to restore faith in growth investing. However, the lessons of the recent past (when many growth stocks proved to be just as vulnerable to a more hostile economic background as any other company) should not be lightly dismissed.
Selectivity, rigorous stock selection and a well-ordered investment process have stood the stern test of the recent bear market. They will continue to add significant value even in a more optimistic market environment, at least after the early stages have been completed. However, investors are initially likely to target leading sectors (such as banks, oils and pharmaceuticals) on the basis of their superior liquidity. Thereafter, more considered views are likely to come into play.
My own approach is to target good quality stocks offering attractive valuations, which have fallen out of favour for a variety of reasons. This is a very stock-specific exercise, requiring wide knowledge of the stock market and access to company managements. The strong performance of the M&G British Opportunities Fund during both the technology, media and telecoms boom and the subsequent rotation into old economy companies supports the validity of this approach in contrasting economic/stock market environments.
Shares in mid-cap and smaller companies have generally lagged behind blue chips during the recent market rally. The significance of their relative lack of liquidity has been explained earlier. A further short-term consideration is the sectoral shift within the main UK equity indices, which has seen technology stocks relegated from the FTSE 100 Index (where their current weighting is only 0.7%) into the FTSE 250 and FTSE SmallCap indices, where their respective weightings are 5% and 13%. According to the FTSE Actuaries Share Indices table, the price earnings ratio of the FTSE 250 is 16.6, against 19 for the FTSE 100 and 36 times for the FTSE SmallCap Index. This implies that value is emerging for mid caps but not yet for smaller companies, even after their heavy (29%) decline during the year to date.
The upshot of these movements during the longest bear market since 1972-4 is that it is again possible to identify good value in the stock market. But investors will need to exercise great care in stock selection, since short-term economic weakness and the associated risks of further profits warnings are likely be influential. It is comforting that, although the equity market (on a current price earnings ratio of 19) is not unduly cheap by historic standards, it appears unusually lowly valued against gilts.
Global influences remain paramount for the UK economy.
The consensus view is that low interest rates and a rise in public spending will lead to a recovery in the second half of 2002.
Traditional valuation tools like dividend yields have made a comeback.
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