“Hey, Banksy – what on earth keeps driving the footsie higher?” That was the question put to me on Friday night. And it’s a question that must be on the mind of every investor in the country right now.
For months now, we’ve watched the FTSE climb and climb. And I’m sure from time to time you’ve worried about the prospect of a major correction in the stock market. The kind of correction that brings back sickening memories of 2007 and 2008.
Well today, I’d like to tell you exactly why I think the footsie is flying. And why, despite fears of a market correction, I recently upped my UK equity allocation. Because it strikes me that regardless of a stagnating economy, many corporations are doing just fine. Here’s why…
Why I’m buying British stocks
• Corporation tax is falling. Corporations have become adept at playing national tax regimes off against each other. Companies have never been more mobile, and in order to attract (let alone hope to retain) corporation tax receipts, many governments have been lowering tax demands.
Despite horrific budget deficits, Osborne has continually lowered corporation tax. First from 25% to 23% - and next year it goes down to 21%. Quite a boon for corporations!
• Borrowing costs plummet. Low interest rates and a dearth of places for investors to put their savings mean that large corporations can borrow incredibly cheaply. Corporations have taken to increasing debt, and reducing equity through share buybacks. This is great for company earnings.
Basically, fewer shares in issue mean earnings per share increase. Not only that, but interest payments on debt (as opposed to dividend payments on equity) can be offset against tax... that pushes earnings up too.
• The weak pound. The low pound is good for company valuations. Not only does it make our exports cheaper (boosting revenues), but our companies look cheaper to foreign investors too – foreign investors may be inclined to pick up stock in some of our great multinationals. And anyway, about two-thirds of the FTSE 100 earnings come from abroad... in sterling terms, earnings are mostly going up.
• Global outsourcing boom. Though there has been a lot of talk about bringing manufacturing back to the UK, the truth is many companies are still making the most of cheaper foreign inputs. After all, many of our successful global leaders are enjoying growing sales in the emerging markets. Offshoring production makes a lot of sense – and it’s still going on – it may not be good for our economy, but it’s good for the bottom line.
• Less excess capacity. Free market economies suffer recessions. They’re really a product of the credit cycle along with what you might call the fear and greed cycle. Classically, during the boom, businesses add capacity... that is, they expand – greed is pushes company bosses to raise the bar. And during a recession, fear takes a grip. People demand less stuff – over-capacity leads to knockdown prices and company profits fall.
But in many ways, the corporate titans don’t suffer the classic excess capacity issues. These days things like cars are mostly made to order. Corporate inventory is actively managed... there’s a lot of evidence to suggest there is very little ‘excess capacity’ in the system. Effective management of the supply lines allow companies to maintain margins despite a recession.
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• Valuations don’t look stretched. The five points just listed contribute to a strong set of fundamentals for many of the FTSE 100 stocks. Earnings have been doing okay despite the harsh economic climate. And even with its decent run, the FTSE 100, trades on 14 times earnings. That’s pretty much in line with its long term historic average.
Now, arguably, with interest rates seemingly stuck at rock-bottom, many say the FTSE deserves a higher than average valuation. Maybe even into the twenties?
I don’t know about that. But by my reckoning, the market isn’t in bubble-like territory. Anyway, there are just too many equity bears about for that to be the case.
• Fund managers have gone soft. Over the last decade or so, many of the large pension fund managers have gone soft. Having suffered the millennium collapse and then the 2008 crisis, the City pros turned equity holdings over to bonds. But now bonds look... well, let’s just say fully valued. Money managers tend to move slowly and with the herd – and the herd is getting back into equities.
• Inflation hedge: If inflation comes back, equities should offer some protection. Thats why fund managers want in. Many call this the great rotation – and there's a lot of truth in it.
• Momentum. Leaving fundamentals to one side, markets tend to have a self-fulfilling nature about them. That’s why so many people pursue momentum investing. The idea is that you wait for a market to build up a head of steam, then you just jump aboard for the ride. Just make sure you get out before the correction!
Others play momentum without realising it. Sitting on the sidelines watching the market go up is not a great place to be. Many jump aboard for fear of missing out.
Now, clearly, momentum sows the seeds of its own destruction. I wouldn’t like to say exactly how long the ride might continue. After all, the market has been pushing upwards for four years now.
But many investors are less concerned about a market correction than they otherwise might be...
• Your free insurance policy. Though it’s not an express objective of the Bank of England, it strikes me that quantitative easing (QE) – or money printing if you like – is in part, about reflating equity markets.
And it’s worked. The central bank prints money to buy bonds. The bond holders reinvest some of the proceeds in equities. Equity markets go up.
For better, or worse, equity holders feel richer – it’s the ‘wealth effect’. And people that feel richer spend more money in the economy. In a nutshell, rising equity markets are good – and falling markets are bad.
In the event of a market correction, many expect the planners to pump them back up with QE. What a fantastic and free insurance policy!
These ten pointers are in no way intended to be an advert for rushing into stocks. I just thought it would be useful to summarise the main reasons why the FTSE keeps plodding on, despite the ferocious conditions out there.
For the moment, I’m sticking with equities. For better or for worse, there seems to be a fair bit of momentum in the market.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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