FTSE will break 6,000
FREE email from MoneyWeek
Discover the latest profit opportunities and understand what’s really going on in the investment world with our punchy daily email. CLICK HERE
This genius investor does dizzying levels of research to uncover...Half Price Shares!
The outlook might be bleak for the economy, but that doesn’t necessarily mean that equities will suffer. James Ferguson explains why he thinks the FTSE is heading up.
The outlook for the UK economy is not good. With high household and Government indebtedness and a house-price crash on the horizon, history suggests consumption, GDP and sterling could all fall this year and next. This mix will most likely trigger a consequent rise in both unemployment and inflation - a scenario we addressed at some length in last week’s MoneyWeek. No wonder Thomas Carlyle called economics “the dismal science”.
However, contrary to most people’s expectations, that doesn’t mean that the outlook for the stockmarket is equally miserable. Don’t forget that, last time the housing market crashed, the stockmarket turned in a pretty robust performance. Indeed, I’d go so far as to argue that the stockmarket is already languishing some way below the level justified by current conditions and that, even if earnings growth runs out of steam, the FTSE will see a strong performance in 2005. How do I know this? It’s all to do with bond yields.
The dismal economy
One of the few uplifting stories to come out of the Indian Ocean disaster was the tale of a precocious 11-year-old girl holidaying in Thailand. She’d seen a video in her geography class at school in Britain about tsunamis and realised what the sudden retraction of the sea - the sea level retracts dramatically just before a tsunami - meant. Her insistent warnings led hotel staff to clear the beach and she reputedly saved over 100 lives. If we could run a video in an economic history class of the last time there was a housing crash, it would show that there is a similarly vivid warning when a housing crash is about to strike: a dramatic fall in the number of house sales.
The earliest indicator of this collapse in demand is in the mortgage approvals data. In November 2004, just 77,000 mortgages were approved; a 43% decline on the 134,000 mortgages signed off in the same month a year earlier. History suggests that whenever mortgage approvals total less than 85,000 a month, real house prices tend to fall, as they are currently doing. The bursting of a credit-fuelled housing bubble such as this should then very swiftly impact on Mortgage Equity Withdrawal (MEW) and therefore household consumption spending. Although data for the fourth quarter is not yet out, MEW in the third quarter was £4bn less than it was in the fourth quarter of 2003, according to the Bank of England. That’s a drop of 25% in just nine months. So it should come as no surprise that the British Retail Consortium (BRC) has rated this “the worst Christmas in the last decade”. Richard Ratner, retail analyst at stockbroker Seymour Pierce, reckons it could yet turn out to have been the worst Christmas for the high street since 1979.
A miserable year for house prices
The logical, if not inevitable, consequence of all this is a miserable year for house prices in 2005. Research by Halifax shows that, in the six years between 1989 and 1995, nominal house prices ended the period 13% lower than when they’d started. However, inflation at that time was running at near double-digit rates, so in inflation-adjusted terms, house prices nationally really fell 35% and a punishing 45% in Greater London. Because inflation is so low now, this implies that actual house prices could fall even more than in previous downturns, when most of the adjustment was due to prices for everything else going up instead of house prices coming down.
This in turn will further drive down consumption through what economists call the ‘negative wealth effect’. Basically, as most people’s principal asset sinks in value, they respond by cutting back on spending and boosting savings. GDP is likely to dramatically undershoot Gordon Brown’s target, and that means he’ll need to borrow more. That will make sterling an obvious casualty. A weak sterling - along with a tight labour market and firm factory output prices - will then mean inflation. Sounds nasty, doesn’t it? Surely none of this can bode well for stocks? Or can it?
The healthy stockmarket
“What actually happened last time house prices fell for a sustained period?” wonders Patrick Hosking in The Times. “Curiously, the stock- market weathered things remarkably well.” Shares initially fell about 14%. “But,” observes Hosking, “from the autumn of 1990, less than a quarter of the way through the property downturn and with the wider recession still in its infancy, [shares] bottomed out. By the time house prices really started to plummet, share values were already rallying.” One reason for this, as Hosking notes, is the fact that when sterling was ejected from the exchange-rate mechanism in 1992, interest rates were allowed to fall, as was the pound. From late 1992 onwards, a falling currency triggered a turnaround in the outlook for corporate profits. Exporters were delighted, of course, because their products became more competitive abroad, but domestic companies also benefited. Not only were overseas competitors’ imports suddenly more costly and easier to undercut, but imported inflation gave the firms better pricing power, which led to margin expansion. Not even all the sectors exposed to housing suffered. As Hosking explains, “expected casualties such as the mortgage banks were virtually immune in the 1989-95 slide: Abbey National soared serenely on throughout the period, its shares rising from 150p to 500p”. This time around, the banks could also remain unscathed. Average loan to value (LTV) ratios are reportedly much lower than in 1989, implying the housing market would have to fall even further before negative equity kicks in and the banks face an actual loss on their books.
Of course, it wasn’t all good news. “Some individual stocks were harder hit,” admits Hosking. “Housebuilders fell by more than half in the three years to Black Wednesday, but […] the real casualties were specialist lenders.” Shares in National Home Loans (now renamed Paragon and targeting buy-to-let investors), which lent to the self-employed and other non-standard borrowers, rose by 200p to £12 in the first two years of the housing downturn, but collapsed in a matter of months to 12p despite looking pretty cheap in price-to-earnings ratio (p/e) terms - just as the housebuilders do today. The lesson here is that even very low p/es are scant defence for single-product companies whose businesses are geared to the downturn.
How bad economies help stocks
But why should such a lousy economic environment bode well for stocks? For the answer to this, we have to go back to basics. In an October 2003 publication entitled What Drives the Markets?, Bob Yerbury, CIO at Invesco Perpetual, put it as succinctly as anyone. “The equity market,” he wrote, “is driven by the prospects for company earnings and crucially the valuation which is placed on those earnings” (my emphasis). The important point here is that it’s the “prospects” for firm earnings, not actual profits (which are by nature backward looking), that matter. In September 2003, Investors Chronicle cited a study that confirmed that actual profits “explained only 14.7% of annual stock price moves” for the FTSE 100 for the eight-year period 1995-2003.
Of course, most good investors aren’t bothered with results, which they see as yesterday’s news, but with what they expect this year’s and next year’s profits will be. As they say in the market, ‘buy on rumour and sell on fact’. Analysts and fund managers spend most of their waking hours trying to determine what company profits will do over the next 12 to 18 months. It is generally agreed that trying to look any further ahead is tantamount to divination and hence futile. However, although earnings prospects generally travel in the same direction as the index, and at the same time, forecasts alone can’t explain most of the magnitude of the movement of the FTSE 100 since 1989. There is a lot more to forecasting share prices than accurate earnings forecasts alone.
One of the most vital elements is valuations. Notably, although earnings forecasts are just 22% higher now than they were in September 1989, the index has doubled. This means that, whereas the p/e back then was a little over ten times, it is now what many people consider an “unsustainably high” 17 times. This alone has led many commentators to forecast a weak market. But things are not as simple as that. The second part of Bob Yerbury’s tenet is the valuation (in p/e terms) that the market places on its earnings forecasts - and that in turn is determined by long-dated gilt yields.
It’s all about gilts
As Warren Buffett famously pointed out, if you break the post-war US stockmarket up into those periods when the economy was growing strongly and those times when interest rates were falling (generally when the economy was at its weakest), you find that almost all the phenomenal growth in the indices has occurred during the periods when interest rates were falling. This is because there are essentially just two ways for the index to (justifiably) double: for sustainable earnings to double, or for the valuation the market puts on those earnings to double. The latter is much easier. Inflation aside, it’s the slow and laborious business of decades to double the whole economy’s sustainable profits - it can’t be done at much more than the real GDP growth rate. But halving bond yields, which effectively doubles the appropriate value put on earnings, can take just a few years. Indeed, Government bond yields have been significantly better at explaining FTSE performance over the past 15 years than earnings forecasts. That said, they didn’t do a very useful job all the time. Between 1994-8 and 1999-2001, for example, the relationship seemed to break down.
My conclusion? To understand why stock prices have behaved as they have it is necessary to incorporate both earnings forecasts and gilt yields into the equation. If earnings forecasts are adjusted for long-term interest ratesand then compared to the index, the relationship suddenly becomes very close indeed, giving us a proper model for explaining both the timing and the magnitude of past stockmarket moves for the past 15 years. Even if we can’t exactly forecast the future (we don’t know how gilt yields and earnings forecasts will behave), we can still see whether today’s index is “correctly” priced.
Happily, even the double-digit rally in the FTSE over the past few months can’t obscure the fact that there has been a dramatic improvement in the environment for stocks, driven partly by lower gilt yields and in larger part by the 20% increase in earnings forecasts over the past 12 months. To me, this seems to herald a move not just through 5,000 for the FTSE, but towards the 6,000 mark, regardless of how badly the UK economy gets hit by the housing crash
FREE! For all our latest advice on making profitable investments, claim your 3-week FREE trial of the MoneyWeek website and magazine now.
Money Morning is the FREE daily email from MoneyWeek
– a punchy round-up of the latest investment news and profit opportunities.
DON’T MISS IT!
