By Haydn Davies is an economist at BGI The UK market has looked more and more despondent in rece...
By Haydn Davies is an economist at BGI
The UK market has looked more and more despondent in recent weeks. Not even at the turn of the year, when the economy was coming perilously close to recession, was the UK market so downhearted.
The truth is that although times could be better, there is no crisis. Market sentiment was knocked first by the scandal surrounding Enron. And then WorldCom's admission that it had dressed up its accounts gave investors cause to ask whether they could believe anyone on Wall Street.
With the US stock market setting the mood for all the world's markets, it is not surprising that for the time being investors will seize on any piece of bad news to justify their worst fears. But sentiment can turn and a strengthening economic climate together with better fundamentals should help to lift investors' spirits.
Last year was not a good one for firms' profits but signs suggest the worst is now over. One indicator of the profits outlook is the number of upgrades investment analysts are making to their profit forecasts relative to the number of downgrades. This has been on a rising trend since bottoming last November, suggesting that companies are restoring their profitability.
One reason why the earnings outlook has been improving is a recovery in overseas orders. The UK economy weathered last year's global slowdown well, thanks to consumer spending.
But the UK stock market does not have many firms in the industries that are expected to do well out of strong consumer spending, such as car makers or consumer electronics firms. The consumer boom, therefore, has not done much to lift the UK stock market, or to compensate for a collapse in overseas orders.
With the global economy now off the sick list, a pick up in overseas orders will help economic growth become more broadly based, and cheer investors. Moreover the pound's slide against the euro will give an extra boost to those firms that make many of their sales in Europe.
An improvement in the economic climate could be just the tonic investors need to encourage them back into the market. And at current levels, the market may not be a bargain, but it is looking reasonably cheap. The earnings yield is, of course, just the inverse of that widely used yardstick: the P/E ratio.
After the turbulence of the past few weeks, the market is trading on a prospective earnings yield of around 5%, about the same as the yield offered by government bonds. On this rough-and-ready test, therefore, the stock market is looking increasingly attractive, given that firms should be able to grow their earnings over time.
Of course, one thing that could sap some of the market's attractiveness would be a rise in bond yields. But the Bank of England (BofE) is not expected to raise interest rates by more than 0.5% before the end of the year.
And consumer spending, about which the BofE has been concerned, should moderate of its own accord as lower wage settlements and an end to further cuts in mortgage rates curtails households' spending power.
Our view is that the market presents an attractive buying opportunity that should pay dividends as sentiment improves.
Equities are cheap at present.
A weaker pound helps exporters.
The global economy is recovering.
Profitability remains weak.
Investor sentiment is frail.
Sustained US recovery not guaranteed.
Outlook for income
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