On the up?

A very big milestone was passed this week when the FTSE 100 passed – and closed above 5000 for the first time in almost a year.  This has been hailed as significant and almost unbridled optimism seems to be pervading the stock market now.  What a difference six months makes!  In March all was despair and despondency: we were in the worst downturn since the 1930s and only a miracle (or so it seemed at the time) could rescue the global economy from meltdown.  Clearly this was overstated but it tends to be a habit with the market: could this new mood of emerging from the shadows also be an exaggeration?

On the plus side, the past week saw an important development: the re-emergence of takeover activity on an international basis.  Kraft, the US food giant, bid for Cadbury, the stalwart British company, which is, predictably, making all the usual noises that the bid undervalues it.  In reality Cadbury is in play.   In addition we have seen the possibility of a merger between two of the leading UK mobile phone networks, Orange and T Mobile.  All this augurs well for the future.  It is also noticeable that the current economic news has subtly changed to a more positive tone.  The media is generally interpreting the latest economic indicators as showing that we are approaching the end of the recession and that a return to growth is imminent.

So what is going on?  Can we now happily shrug off all the talk of deflation, depression and financial Armageddon?  Perhaps not: witness the bear market rally of more than 50% in US stocks in 1930 before collapsing to new lows.  Should the economic rally falter and the banking system experience renewed turmoil, there could easily be another massive sell off.  Bear in mind the valuation of the indices: on very few measures could the market be said to be cheap, particularly sections of it, such as the FTSE 250 which now sits on a price/earnings ratio of over 25 – this leaves little room for disappointment.  Also remember that next year it seems likely we will face a change of government and with that comes all the eager actions of a new administration; serious cuts in public spending and higher taxation perhaps?

Is this huge reversal of fortune in the last six months warranted?  The market has turned decisively in favour of cyclical stocks (those likely to benefit most from economic upturn) away from the defensives, which are unloved and underperforming.  As already stated, markets traditionally overreact.  This is well-known and obvious.  What is less certain is when this will be reversed.  The overreaction is being driven by those investors who are worried they have missed the boat and are therefore piling in now in an attempt not to be left behind altogether.  This could prove to be costly; following the herd rarely leads to sustained outperformance.  Stick to fundamentals: there are some sectors that look expensive and profits should be taken, but equally there are those which are out of favour and look to offer reasonable value.

This does not constitute a recommendation to buy or sell investments and the value of any shares may fall as well as rise. Investments carry risk and investors may not receive back the amount invested.  The views expressed are those of the author and not necessarily of Cunningham Coates Stockbrokers.

Disclaimer

By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.

Cunningham Coates Stockbrokers is a trading name of Smith & Williamson Investment Management Limited.  Authorised and regulated by the Financial Services Authority.