Market view

Joy of joys – April was the UK stock market’s best month for five years. It is hard to remember when we last heard stories of bears being taken to the cleaners but it is happening again. Between 2 April and 2 May the FTSE 100 Index jumped by 5.31 per cent to 3,952.59 and shortly afterwards it burst through the psychological barrier of 4,000.

The advance was broadly spread with only the defensive sectors (i.e. personal care) and resource stocks missing out on the party. The star sector was steel. This is a one stock (Corus) sector and in March it had slumped on fears that it was about to become a no stock sector. Elsewhere the rally was lead by either the bombed out (i.e. Information Technology) or the cyclical recovery plays (i.e. Automobiles & Parts) on hopes that the real economy might at last be seeing some green shoots.

The FTSE 250 Index performed even better than the blue chips, largely because it was not pegged back by a heavy weighting of oil and mining stocks. Between 2 April and 2 May it jumped by 9.76 per cent to reach 4,416.87. And as a sign that small investors really do have confidence that the bear market is at an end, small caps led the way. The FTSE Small cap Index jumped by 11.79 per cent during the month to close 2 May at 1.858.19.

Is it a mirage?
After three years of a bear market an investor encountering a savage rally in equity valuations must feel like the desert traveller crawling on his hands and knees at the point of giving up who suddenly finds himself on the edge of a large lake. He has seen so many mirages along his journey that as much as he wants to believe that he really has found salvation, he almost won’t let himself believe it.

Of course the April rally might just be another mirage designed to torture investors thirsting for relief. The most savage rallies always occur during bear markets. They are designed to suck in fresh fools while at the same time forcing bears to close short positions as the margin calls mount. It is that forced closing of shorts that makes the rallies so savage. So the question is: was the April rally just a bear squeeze or the beginning of the end of the bear market.

There is no doubt that sentiment has changed. Just take a look at the way that shares in biotech or IT tiddlers have raced away or at the number of IPOs being mooted. Two months ago such stocks were regarded as worthless today the punters love them. Has anything fundamental changed? No. Many of these stocks probably were worthless two months ago and probably still are. If they are loss-making, achieving a refinancing is still tough given a tightening credit squeeze by the banks.

On the other hand, as the FTSE 100 touched 3,300 in March it was possible to buy solid, profitable, well-financed, cash generative blue-chips, which yielded well over 6 per cent, and to buy small caps, which were trading at around break-even but had net cash at huge discounts to that net cash. When you can buy 50p for 30p you should suspect that something is wrong. What was wrong was just investor sentiment. Two months ago serious newspaper headlines included of “The Death of the Cult of Equities” - that was clearly over-egging the pudding. Equally, suggestions that we are on the brink of a new bull market look to come from the same school of delusion.

There are one or two changes (for the better) in terms of macro-economic fundamentals. The war in Iraq is over (although one cannot argue that the global war on terror is at an end). The price of a barrel of crude has fallen from over $30 to around $25 and some suggest that it may fall much further, although OPEC is unlikely to welcome such a prospect. But cheaper crude is clearly a stimulus of global economic growth as are lower base rates. Although the US Federal Reserve did not cut US base rates in May they are already at 40-year lows and there is clearly scope for a cut over the summer if one is needed. The same is true in the other Occidental economies.

And there are some signs, notably in the US, that after three years of deferring capital investment – notably on IT – at long last corporates are starting to increase their capital budgets once more. You can work using old machinery and systems for only so long.

However that pick up in corporate expenditure – if it is sustained – is very much needed because there have to be doubts about the sustainability of the consumer boom. In the UK there are clear signs of cracks emerging in the housing market and data from the high street seems to vary from month to month. But whilst consumer-spending patterns may vary monthly, the high level of consumer debt does not and at some stage that must surely act as a drag on consumer spending. It is not a matter of if but when. Moreover there are other potential threats to the scenario of a dramatic pick up in corporate earnings: the US dollar remains weak and currency instability can’t help anyone; in the UK taxes are rising both at a corporate and a personal level.

Given that backdrop, not even the bulls are predicting a dramatic growth in corporate earnings growth. Indeed not even the greatest bull of them all (Gordon Brown MP) is that optimistic. Yet at around 4,000 the FTSE 100 Index trades on an historic price earnings ratio of around 17 and yields just 3.6 per cent. Since dividend cover averages a meagre 1.6 times, it is likely that dividend growth over the next couple of years will be even less exciting than earnings growth. Sentiment may have changed so much that such things don’t matter but one looks at the hard numbers, the words “screaming buy” do not leap out at you.

Tom Winnifrith edits the financial website www.t1ps.com