Although investors still seem to be cautious about jumping back into the market, all the signs imply a recovery is around the corner and opportunities can be found using careful stockpicking
Writing articles at this stage of the market cycle is hazardous, as any predictions could look very stupid all too quickly.
Having held distinctly bearish views about the equity market for the past 18 months, I still find it all too easy to think of reasons to retain a cautious stance. However, I am also understandably loath to miss any sustained recovery in markets, something that would normally be associated with an improvement in the economic environment.
Indeed I am not alone as investors on the whole have been trying to call the turn for most of the last year. In 2001, there were three separate occasions when the market was focused on an anticipated V-shaped economic recovery although as each one led to disappointment, it was not surprising that after the September dip and rally most investors adopted a wait-and-see approach.
Understanding the reasons for the earlier disappointments and the nature of this economic recovery will be key to stock selection over the next few quarters. The reason for the belated caution last year was a more realistic view about the US economy.
It took proponents of the New Paradigm some time to appreciate that many of the economic trends in recent years were purely cyclical and having turned down now constitute a considerable headwind to recovery.
However after two years of declining economic growth, the US economy is set to return, albeit possibly briefly, to earlier rates of expansion. After substantial reductions in inventories last year, as it became apparent to companies that previous revenue expectations were overly optimistic, most forecasters now believe businesses will rebuild stocks and expect this to lead to strong growth in the first half of this year.
To play this development, many investors continue to hold technology equipment stocks in anticipation of renewed strength in business investment. As the capital stock in many of these areas remains high by historical standards, this optimism may be unjustified.
The considerable uncertainty over the duration of the current recovery is based on the observation that the leading component of final demand, the consumer, has not exactly been taking it easy over the past year. The low interest rate policy in both the US and UK and continued strength in the labour market, especially in this country, have encouraged consumption.
However, although interest rates are likely to rise over the course of the year, an absence of obvious inflation pressures suggests that any move will be modest and insufficient to change spending habits on either side of the Atlantic.
This suggests investors should persevere with consumer-sensitive stocks and not to adjust portfolios in the face of monetary tightening.
Overall, I continue to find it very difficult to be bearish about the economic outlook. Revisions to US GDP in the fourth quarter of last year suggest that the downturn was far less pronounced while the UK economy showed remarkable resilience, avoiding its usual habit of being first in and almost last out of any global recession.
In Europe, GDP forecasts are being increased. If I have a concern, it involves the growing imbalances in the domestic economy and, in particular, the housing market that has helped to sustain consumption. The cost of housing has clearly become an issue for many sections of the workforce, especially in the south east of the country.
The obvious remedy is to lower the cost of the asset rather than increasing incomes to compensate but I am far from confident that this government or the MPC has the desire to adopt such a strategy and may prefer to pursue the latter option or simply ignore the issue.
With the support of a recovering economy, globally and domestically, one is left wondering why the equity market still sits within the trading range established in the final quarter of 2001. In the UK, the FTSE 100 index has been stuck in the 5,000 to 5,350 range.
The most optimistic excuse for the current malaise is that investors simply want to see the whites of the eyes of this recovery and determine the extent to which company profits are likely to rise. This certainly supports the recent bounce in cyclical stocks.
However, if the UK has weathered the global slowdown well, is it right to assume it will enjoy a conventional recovery? A more muted recovery seems more rational. The London equity market also looks as if it is in need of direction from Wall Street where valuation concerns are most apparent.
Optimists can reasonably expect rising productivity to benefit the profit line as output is increased and although the persistence of weak pricing power globally continues to concern me, sooner or later one would expect equities to see a more sustained rally.
However, it will have to achieve this knowing that it is starting with the kind of rating more normally associated with market peaks.
Of more interest is how investors will justify any continued drift or further disappointments from the market? The move by the Boots pension fund to shift out of equities highlights the deterioration in the supply/demand balance for the asset class. We know that mature defined benefit schemes and life funds cannot continue to support equities by increasing their exposure to the extent that they have over the past three decades.
A resumption of large-scale equity issues to fund acquisitions or to address balance sheet problems created in the late 1990s investment boom simply aggravates the perceived problem.
However, equity issues should be accepted at this stage of the recovery and the trend from equity to bonds and other higher-yielding assets reminds me of the concerns in the oil market thirty years ago. After aggressive policy action by Opec, many people confidently predicted an imminent oil shortage with demand permanently exceeding supply. No doubt these concerns will one day be fully justified but clearly not within the timescale initially envisaged.
I am inclined to believe that the equity/bond weighting issue will also play out over an extended period and don't necessarily see it as a barrier to an equity rally driven by more immediate economic forces.
It is a headwind though and if investors become more grudging holders of equity they will probably continue to favour those companies that give them what they need, namely income.
The number of companies cutting dividends is a disappointment. Some are cutting because of financial distress but others purport to do so to maximise growth opportunities.
For years, I used to argue with a colleague who claimed that the value of a share was simply the future flow of dividends. I preferred to place greater emphasis on the opportunities for capital appreciation as long as this could be realised by selling. If pension funds are income hungry, they will want to hold income generating assets and switch out of low or non-yielding holdings undermining my previous stance.
After a decade of economic expansion on both sides of the Atlantic, there is a risk that many companies have pursued strategies and created balance sheets that are unable to meet the needs of their investors.
Directors may wish to pursue policies designed to maximise the value of their share options but investors may now have a different agenda. This would place a significant premium on those select companies that have strong cash generation, operate in relatively stable industries and openly pursue a progressive dividend policy.
Of greater concern is the general level of equity markets globally and the US in particular. Many investors argue that current equity levels are justified by bond yields. Their position is predicated on equity and bond yield movements over the past thirty years, but conveniently forget the lessons of earlier periods and I struggle with the basic premise.
In the equity market, individual companies are broadly afforded ratings related to their PEG ratios ' the higher the sustainable levels of earnings growth the higher the rating. If this holds for individual companies then it is not unreasonable to expect some correlation at the market level. However, lower bond yields only benefit equities so far. Once yields have fallen below a certain level the implied economic environment is simply not conducive to the growth in reported company earnings.
This arguably leaves equities in an awkward dilemma. If bond yields decline from current levels it will be for reasons that undermine investor confidence in the economic recovery.
However, if yields rise this conflicts with the bull case for equities. Of course all market cycles throw up occasional contradictions but they are unhelpful at the bottom of the economic cycle. One of the key drivers of the equity bull market in the 1990s was the steady decline in gilt yields that had hovered just below 10% for a number of years.
Many investors interpreted this decline in long yields as a case of bonds leading equities. It is difficult to envisage a repeat performance other than in a direction that is detrimental to both asset classes.
One of the lessons from the technology bubble is that extended time horizons in investment are dangerous. Maybe I am being overly cynical but I always chuckle at the willingness of investors to buy shares in companies where the investment horizon extends beyond the date for the exercise of the management's share options.
I still feel very comfortable holding companies with strong cashflows, good market positions and a healthy appreciation of the importance of dividends. This does not preclude growth stocks but I cannot see investors collectively falling for the worst excesses of the last run in this area of the market so soon.
The low interest rate policy in the UK and US has encouraged consumption.
With the support of a recovering economy, it is difficult to understand why the UK equity market still sits within a trading range established in Q4 2001.
If bond yields rise, this conflicts with the bull case for equities.
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