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OPINION

Reasons to be bullish

Reasons to be bullish
December 21, 2012
Reasons to be bullish

However, climb the market certainly has, and in the past 12 months both the FTSE 250 and Small Cap indices have posted gains of over 20 per cent before factoring in dividend income. That is even more impressive when you consider that these gains have been notched up in the face of an ongoing eurozone debt and economic crisis; anaemic growth in the domestic economy, which for a large part of the year was in recession; and with the US administration running out of time to reach a compromise to prevent the economy falling over the precipice of a fiscal cliff next year.

Zero interest rate policies (Zirp)

As difficult as it may be to comprehend how the stock market has managed to take such a barrage of bad news so well, there are some quite logical explanations which also serve up the real possibility that the current bull run in equity markets has some way to go. The most obvious starting point lies firmly at the door of all the major central banks, whose ultra-easy monetary policies and government bond buying programmes remain highly supportive of equity markets. It is no coincidence that the best of the equity market gains since March 2009 have come when these quantitative easing (QE) programmes have been running at full throttle and fuelling the so called 'risk on' rally in a variety of asset classes, including equities. That is understandable as investors are far more inclined to seek higher-yielding investments when central bankers are hell bent on driving down government bond yields to record lows.

In fact, with UK 10-year gilts yielding a paltry 1.82 per cent - in effect, a negative real return when you factor in inflation - equity strategists at investment bank Citi point out that UK equities are as cheap now as they have been at any time in the past 100 years relative to UK gilts. There is significant dividend support, too, and the real possibility of growing income streams to attract investors to equities. As Jeremy Batstone-Carr, head of research at Charles Stanley rightly points out: "Dividends are likely to grow in 2013, although probably at a lower rate than the expected 10 per cent in 2012, and the appetite for income has not lessened."

Moreover, following last month's gloomy autumn statement from chancellor George Osborne, there is nothing to suggest that the Bank of England has any other choice but to continue its very supportive policy of depressing UK government gilt yields in the face of a domestic economy struggling to generate any meaningful growth; consumer spending undermined by below inflation wage settlements and underemployment; and an economy suffering from fiscal contraction.

 

 

That may sound depressing stuff, but it is actually rather good news for both the finance departments of companies and home-owners, who are benefiting from record low rates on mortgages. This is in turn supportive of the housing and construction market. The weak domestic economic backdrop is also good news for inflation, which has been falling this year.

Not that Mr Osborne is alone. The US central bank has been employing similar tactics and, at last week's Federal Open Market Committee (FOMC) meeting, ratcheted up its QE3 monthly bond buying programme to an aggregate $85bn (£53bn) of Treasuries and mortgage-backed securities a month.

But the real game-changer for equity investors has been the decision by the European Central Bank (ECB) in late summer to finally agree to launch its bond bazooka, employing its massive balance sheet to purchase government bonds from the southern Mediterranean block of countries in order to stop the region's debt contagion spreading any further. This policy decision, albeit belated, had bond bears running for cover and resulted in the subsequent dramatic fall in secondary market yields for both Italy and Spain in the past four months. As a result, a significant amount of risk embedded in equity market valuations due to a potential break up of the eurozone has been removed.

Don't underestimate the implications of the ECB's largesse on the banking and financial sectors, either, after the central bank gave a lifeline to 589 of the region's banks, including UK ones with European operations, by providing an eye-watering Ä1 trillion (£810bn) line of cheap three-year money in the first part of this year as part of its longer-term refinancing operation (LTRO). This has removed the Armageddon scenario facing equity markets at the end of last year. Moreover, there is now a very real possibility that the ECB will now reduce its deposit rate in the first half of 2013 into slightly negative territory to support bank lending in the region. That has positive ramifications not just on the continent, but for UK companies, too, since the eurozone accounts for around half of total UK exports.

It clearly also would have positive implications for the banking sector, which has already rallied 30 per cent since the start of the year. It's no coincidence either that all of these gains have been made since late summer when the ECB announced its bond bazooka. The resulting easing of stress in the financial sector has been a boon for life assurers, too - all of which have substantial holdings in the corporate and eurozone bond markets. In fact, the FTSE 350 life assurers have been one of the best-performing sectors in the second half of this year, rising almost 40 per cent from their low point in June, as the risk of a eurozone break up diminished, secondary market bond yields contracted and equities rallied. On a price-to-embedded value basis, and supported by decent dividend yields, the valuations here still don't look toppy.

 

 

Equity risk premium

The other implication of the ultra-easy monetary policies of the major central banks has been to reduce the equity risk premium demanded by investors to hold equities. Assuming no further flare ups in the eurozone or the US, it is only reasonable to assume that we could see equity market volatility trend down and risk premiums contract further in the first half of 2013. In this environment, investors are far more inclined to concentrate on the valuations on offer rather than focus on capital preservation - which was the number one objective during the periods of market volatility earlier this year.

On this count, equities are hardly overvalued. Equity strategists at JPMorgan Cazenove point out that the MSCI Europe index is trading on 11.1 times 12-month forward earnings, which compares favourably with a median rating of 13 times for the past 25 years. UK equities are even cheaper, according to the bank's analysts, with the domestic market rated on 10.5 times 2013 EPS estimates, a full two points below the average forward 12-month multiple in the 2003 to 2007 bull market. It's worth noting, too, that the rating for the UK market factors in EPS growth of 5 per cent, which may seem punchy given the economic backdrop, but comparatives are generally soft as UK earnings have fallen by an average of 8 per cent in 2012, driven by weakness in the commodity sector.

Profit margins

Bears of the current bull run will rightly point out that corporate profit margins are now at a 70-year high and, with growth clearly hard fought in certain sectors, margins could be set to roll over. However, that would be a very brave call to make at this point unless there is another major shock to the global economy, because in the 11 cycles in the US since the Second World War, there has never been a downturn before margins peaked.

Moreover, the S&P 500 only peaked out five quarters later on average after margins hit their high point in these 11 cycles, albeit there were three occasions when the S&P 500 topped out a few months before the peak in margins (January 1973, November 1980 and June 1948). In other words, to turn bearish on equities now you would need to assume that the US is about to go into recession despite the fact the Federal Reserve is maintaining a highly accommodative policy and one supportive of equities. And given the high correlation between moves on Wall Street and the UK stock market, which is not surprising given the US is a major trading partner of ours, further upside in US equities has obvious positive implications for our own market.

True, if President Obama and congressional leaders cannot reach an agreement in the coming weeks the US will be hit by a fiscal contraction worth $600bn (£373bn) in 2013. That clearly would be enough to tip it back into recession. However, as we witnessed with the resolution to the country's debt ceiling last year, this may go to the wire. But given there is an incentive for all parties to reach agreement, a resolution seems inevitable.

 

 

History lessons

History books also point to the bull run having further to run. As the well-respected stock market historian David Schwartz notes: "UK seasonal stock market trends are also worth reflecting upon. There were 37 years since 1960 when a bull market was running at the end of October. The UK stock market rose in the next six months 34 times. There are no guarantees... but even pessimists would have to agree this is a very strong trend."

It will not have been lost on investors either that the FTSE 250, which is representative of the UK economy, is on the verge of taking out the record high of 12282 hit in May 2007, having failed at this level in July last year. From a technical perspective, a close above 12300 would be very bullish indeed and one that should see the mid caps continue to outperform the FTSE 100, whose weighting of around 30 per cent to oil and mining sectors (two of the worst performing sectors) in 2012 has proved a drag on the index this year.

Along with the small caps, the FTSE 250 would be my favoured index to play the current bull run in the first half of 2013. In the FTSE 100, expect financials to continue their second-half outperformance as the index tries once again to breach the 6000 level.