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Finding a sweet spot in the FTSE market mayhem

Monday 3rd November 2014

By Mike Franklin, Chief Investment Strategist at Beaufort Securities
Since mid-May 2014, the FTSE 100 Index has fallen by around 10% to the 6,100 level. It is a sobering reminder of the enduring truth of the financial world that, whatever you think it may be worth, the value of an asset at a particular point in time is only what you can sell it for. Attempting to assess the strengths of underlying economic and other financial support for the markets whilst trying to discount the implications of ever more geopolitical events has become effectively impossible. This is where the analysis of technical data by investors can provide valuable guidance. 
However, when the latest bull market trend line, in place since March 2009, was broken earlier this month, investors lost an important reference point. In technical terms, the psychological context for the market was changed. Whether it is for a specific overriding reason or a combination of several, investor confidence has taken flight.
During a presentation in April 2014, based on a reading of the technical data, I expressed the view that the 2009 bull market might be approaching a peak. So far, the highest closing level for the FTSE 100 Index has been 6,878 on the 14th May 2014 although, intraday, it did reach 6,904 during September. In the past five months, the FTSE 100 Index has lacked the momentum to break up through the previous highs on at least four occasions. 
Undoubtedly, there were several reasons for this but, if investor confidence was uncertain then, an element of panic has emerged since. While this usually leads to indiscriminate selling, it also creates the opportunity to acquire longer term value.
So what is the current outlook?
1. Quantitative Easing by the US Federal Reserve is due to end this month after several months of tapering. Further QE seems unlikely though not impossible.
2. The next logical step is for interest rates to start to rise though not imminently. Speculation about the timescales on this been extending to H2 '15 (UK) and even beyond this in the US as the rate of economic recovery has appeared to be threatened in recent weeks.
3. The Eurozone is struggling again as inflation falls towards zero or below, raising fears of a Japanese-style depression. Notably, German economic data has been indicating a slowing trend, partly on the changing emphasis in the Chinese economy away from conspicuous consumption.
European Central Bank President Mario Draghi has probably done most of what he can through monetary loosening short of introducing a form of Quantitative Easing in the face of German opposition. It is now for the eighteen individual member nations of the Eurozone to stimulate economic activity through structural reforms. The Euro spot rate has been easing, falling by 10% between early-May and early-October but the question remains about how soon the region can restructure itself. Inevitably, there is some wariness ahead of the ECB's latest bank stress test results due out on the 26th October.
Most recently, political uncertainty in Greece reflected in the Government's 10-year bond yield jumping above 9% earlier this week has revived fears that aspects of the old Eurozone Crisis are returning.
4. The nature of economic growth in China appears to be being compromised by the continuing difficulties in the property sector although an annual GDP growth in excess of 7% is still expected for this year.
5. Recovery in the US and UK economies has been holding up well but some impact from slower growth elsewhere, particularly in the Eurozone, seems unavoidable.
6. Commodity prices have generally come under pressure in recent weeks although the widespread uncertainty is giving support to the price of gold. While production of oil (and shale gas) has held up, slowing consumer demand has seen the oil price fall by 21% to $81 per barrel since late-June with more than half of that in the past three weeks. Though usefully disinflationary, it does raise questions about the extent to which perceived slowing global growth is behind this. 
This has also been mooted as a factor in the falling price of raw materials although the weakness of iron ore price owes much to aggressive cost reduction by the main producers such as Rio Tinto and BHP to drive out inefficient competitors from the market.
7. Unresolved geopolitical issues persist in the form of the conflict with Islamic State in Iraq and Syria as well as President Putin's incursions into Ukraine which have led to mutually trade-damaging sanctions. The threat from the Ebola virus - as yet not fully assessed and contained - could pose practical challenges to world travel and compromise economic activity.
It can be seen that a brief review of some of the main fundamental issues facing investors does little to suggest the levels at which the selling pressure will subside. Typically, when markets are in free-fall, the question goes up.....
'When will the investment fundamentals re-assert themselves?'
It is also worth remembering that, though sellers are dominant in the down trend, there are still, for better or for worse, buyers on the other side of the trades.
On the basis that the key investment fundamental that relates to any investment based on the principle of 'return on capital employed' , it is relevant to consider the relationship between the two main asset classes apart from cash, namely equities and bonds. Investors have their own reasons for holding either or both of these, shaped by their specific risk appetite and financial needs.
For much of the past five-and-a-half years, both equity and bond markets have enjoyed bull market conditions, helped by large injections of Central Bank liquidity. That is now changing with the end of US QE tapering and the prospect, eventually, of higher interest rates.
In a more normal environment without the need for Central Bank intervention, equity markets are usually sustained by the growth of corporate earnings, and so dividend income, on the back of economic growth. Recently, some signs of a slowdown in global economic growth have been emerging. This is not helpful for companies but the impact may not be as great as the effect of higher interest rates on bonds where an inverse relationship exists between yield levels and capital value.
Subject to their view on the likely strength of the global economy beyond the present transition phase back towards a normal economic model, some bond investors may decide to take advantage of this sell-off to avoid potential capital losses on bonds by switching into good quality equities, confident of a maintained income stream and with some protection - not available with all bonds - against inflation. To some extent, this happened earlier in this cycle.
For context, using data from the Bank for International Settlements, despite the near-tripling in value of the equity class since late-2008 (in Asia) and early-2009 (elsewhere) to around $55 Trillion now, the combined value of global bonds at an estimated $80 Trillion is still significantly larger than for equities. Consequently, the potential appears to exist for some switching from bonds to equities after their recent falls.
Dividend yields (excluding special payments) on FTSE 100 Index stocks range from around 9% (mainly supermarkets with a high risk of dividend cuts) down to zero. By comparison, yields range from 2% for Government Bonds to about 4.5% for good quality Sterling corporate bonds. Noting the trend in the US with the 30-year Treasury yield falling below 3% earlier this week, unless you believe it heralds a prolonged economic slowdown, the fall in the long end of the yield curve suggests the bond-to-equity switch is worth considering.
Between the 7th July and the 4th October 2011, the FTSE 100 Index fell by 18% and moderated the course of the bull market. A bear market is usually defined as a decline of 20% or more. We may be experiencing a similar decline now rather than a full-blown 2000 or 2007-type decline.
In an interview with Bloomberg tv in August 2014, I suggested that a correction of around 15% to 20% could be expected. In index terms, this implies levels of between 6,000 and 5,500. By the market close yesterday (16th October 2014), the FTSE 100 Index was just 0.25% lower against a range of 3.3% between the day's high and low. Within all that movement there was a high level of activity at around 6,100. Analogous to braking in a falling lift, investors tend to pick levels to defend and the day's low of 6,072 and 6,100 are in the region of the 6,029 level at which the FTSE 100 Index bottomed after a 12% fall in late-June 2013.
In reality, this level-picking probably has more to do with sentiment than any hard fundamental calculation although it is reasonable to expect the yield argument to make itself felt at some point. What this means is that we may not yet have seen the lowest point of this sell-off but, at least, some objectivity seems to be returning. Certainly, in technical terms, the FTSE 100 Index and many of its constituents have become oversold.

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