Market view
The weather was hot for most of July and for
most of the month stocks – notably – the small
caps – scorched their way to New Year highs. The FTSE
100 Index ended July at 4,157.02 – a net gain of 3.12
per cent on the month with only defensive sectors such as
tobacco and utilities missing out on the party.
The biggest winner was the one company sector
of Steel. This month the market reckons Corus (the one company
in question) is not going bust after all and its shares zoomed
ahead. The other winners were the classic cyclical recovery
plays (Mining and Information Technology) as well as Life
Assurance. While the market continues to rally those nasty
questions about solvency ratios can be forgotten.
However it was the second liners and small
caps that really showed the way – something that historically
happens when base rates are falling (they did again in July)
and towards the end of any market rally (of which more later).
The FTSE 250 Index ended July at 5,325.59, a net gain over
the previous 31 days of 7.3 per cent while the FTSE Small
Cap Index steamed ahead by 7.69 per cent on the month to close
at 2,263.79. Small caps may no longer be trading on price
earnings ratios of 4, 5 or 6 (as legions of them did at the
market’s nadir back in March) but even after this rise
there are many cash rich and profitable small caps on single
figure PE ratios. Hence the buzz about the sub-sector.
Bears on the back foot
Is that a green shoot of recovery I see in Main Street USA?
It doesn’t really matter what I think, the market is
convinced that those green shoots are popping up everywhere.
The bears really are on the back foot.
Coming into the current (Q2) earnings season
in the USA the distinguished market commentator Alpesh Patel
noted that in order for the rating of the US market to be
justified, earnings had to beat analysts forecasts (which
already had growth pencilled in) by 6 to 8 per cent. It sounds
hard but in Q1 earnings beet forecasts by 9 per cent and so
far Q2 has not disappointed. Six months ago the three-year
trend of a grinding ongoing process of downgrades to forecasts
was very much intact. That process has now seen a steady four-month
reversal.
And economic data – although sometimes
sending out off messages – tends to support the idea
that intensive monetary and fiscal stimulation is finally
beginning to have some effect. The US economy never stopped
growing over the past three years but that growth was at times
very sluggish. But on 31st July second-quarter US GDP numbers
indicated that there was some very strong growth indeed coming
through. Even in the Old World with our restrictive labour
practices (a deterrent to re-employ workers); our bloated
governments levying wealth-destroying taxes and generating
enterprise strangling red-tape there are signs of economic
growth. Despite ourselves we appear to be recovering and that
is already feeding through into increased corporate earnings
forecasts.
Perhaps more importantly it is also feeding
through into a marked improvement in investor sentiment. Undeterred
by three years of financial masochism, there are signs everywhere
that both private and institutional investors are back in
the market. Hence the bulls do have some reason in predicting
an ongoing re-rating based on higher forecasts.
Not all good news
But before we get too carried away, there are reasons NOT
to rush out and buy shares indiscriminately. Corporate and
personal debt levels on both sides of the Atlantic remain
at worryingly high levels – with the UK most exposed
at a personal level and the US more exposed at a corporate
level. Long-term interest rates are already starting to increase
(another sign that the economic cycle is turning) and at some
stage this dual pincer of high rates and increased borrowing
levels has to kick in. In the best-case scenario it merely
dampens levels of consumer and corporate spending and dividend
growth. But in a worst-case scenario it produces a very nasty
credit crunch indeed.
There are always the wild cards to consider:
Osama, Saddam, and the Middle East. There has to be some recognition
that the world is a more dangerous place than it was in, say,
1998 and that this needs to be discounted – perhaps
at the margin – in equity valuations.
In the UK there is the issue of the growth
of the pubic sector and the consequent burden of taxation.
The UK government will, by 2006, employ twice as many people
as the Russian and Chinese armies combined on an average wage
of £28,000 (i.e. well above the private sector average).
This largesse can only be supported by even more increases
in taxation. For a country, which has already sprinted ahead
of its rivals such as France and Germany in the taxation stakes,
this is bad news. The tax threat to UK plc should not be underestimated
although economic suicide is generally something that takes
quite a few years to start to take effect.
And finally, there is the issue of valuation.
At around 4,100 the FTSE 100 trades on an historic price earnings
ratio of just over 17. Strip out the financials and that rating
heads up towards 20. Given that retained earnings are likely
to be squeezed by higher taxes and that the UK economic recovery
is still not yet in any way ‘dynamic’ it is hard
to see UK corporate earnings growing over the next twelve
months at anything more than a low double-digit rate. Indeed
it may well be considerably less. As such it is pretty hard
to argue that, at current levels, UK blue chips are outstandingly
cheap.
But among the small caps (a sector written
off in banner headlines just six months ago) there are profitable,
growing stocks trading on single figure ratings. Arguably
they offer value. After recent rallies that may not be outstanding
value but at least there is some upside.
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