FTSE 350: Introduction

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The most obvious indication of this is the performance of fund managers. Normally, the average manager underperforms the index. But for the year to 4 January the average total return generated by open-ended UK equity funds was 24 per cent, compared with 18 per cent for the best index trackers, according to data provider Morningstar. Likewise, our own stock tips put in their best performance for years.

The main reason for this success was that smaller- and medium-sized companies - long favoured by stock-pickers, including at this magazine - outperformed the huge, mature dividend payers that dominate the FTSE 100. Another reason was that the troubles of the mining and oil and gas industries were well flagged a year ago, allowing many stock-pickers to avoid the only sectors that actually lost investors money last year.

With hindsight, the dominant theme of the year was the UK recovery, but - crucially - nobody expected this a year ago. This is why small and mid caps, which tend to be more domestically focused than the highly international blue-chip index, proved such profitable bets. Valuations a year ago were depressed by lingering talk of a triple-dip recession. As the economy unexpectedly moved into a revival phase, led by property and the high street, many companies were dramatically re-rated.

The most obvious beneficiaries of this trend have been the retailers and housebuilders. Yet virtually any company that depends on discretionary UK consumer spending or the housing market saw a strong share price recovery last year, after a bruising three years. These include the likes of ITV (ITV, whose shares rose 84 per cent) and Lloyds Banking (LLOY, up 65 per cent), not to mention the year's biggest flotations: Royal Mail (RMG), Countrywide (CWD) and Foxtons (FOXT).

The key question, of course, is whether the conditions that have rewarded these companies will continue. Our best guess is that they probably will. Britain seems to be in the early stages of a cyclical, consumer-led recovery. Rising interest rates will no doubt temper the mood of optimism at some point, but this seems unlikely in 2014. Inflation continues to fall, hitting 2 per cent for consumer prices in December, thanks to a strengthening pound and falling oil prices. And for all the noise surrounding the 'tapering' of quantitative easing in the US, the central bank consensus remains extremely dovish.

The stock market has risen in line with the outlook, to be sure, but is nothing like as fully valued as the US market. Nor do valuations look stretched relative to history. The ratio of share prices to a 10-year average of corporate earnings (the so-called 'Shiller PE' named after one of two economists that won last year's Nobel prize) is roughly 14, compared with a 30-year average of 18, according to Credit Suisse - although this average is arguably skewed by the late-90s tech bubble.

Perhaps the most worrisome aspect of the current market situation is the bullish consensus. Investors' pessimism a year ago was one of the principal drivers of returns in 2013. If that logic is extended, 2014 is likely to disappoint.

Unless, of course, you defy the consensus. This would involve ditching UK recovery stocks in favour of miners, engineers and other emerging markets plays such as Standard Chartered (STAN), Burberry (BRBY) and Ashmore (ASHM). These former stock market darlings have been hit by an extraordinary reversal in investor sentiment - seemingly provoked by a modest slowdown in the growth rate of developing economies, a clamp down on infrastructure spending by the Chinese authorities as they try to find a more 'balanced' path to riches, and fears of a credit crunch as money is repatriated to the US in search of rising yields.

"When do we get back into emerging markets? That's the big question worrying me," says Jeremy Tigue, manager of the Foreign & Colonial Investment Trust (FRCL). "The long-term argument - that we should be investing in countries with stronger economic growth - still feels right. But it doesn't feel like the moment yet."

Another sector that may, at some point, offer recovery potential is utilities. These have been the chief victims - so far - of Labour leader Ed Miliband's efforts to talk up a "cost-of-living crisis". The costs of political posturing, which also affects the banks, may rise as the 2015 election approaches. But, then again, the fuss could simply blow over. Politics, which is even less predictable than economics, poses a problem for stock-pickers (a subject we will explore more fully in the future).

As for the consensual UK recovery story, the year has already started with a very mixed set of updates on Christmas trading from the retailers. E-commerce seems to be sifting the wheat from the chaff. That's a useful reminder that the economic cycle is not everything: structural change may continue to benefit forward thinkers such as Next (NXT) and punish digital laggards such as Morrisons (MRW), whatever happens with consumer spending. Assessing whether a company belongs to a bygone age or has scope for recovery - crudely, whether it is an HMV or a Dixons (DXNS) - will remain as difficult and as fascinating as ever. We publish our exhaustive review of the largest 350 companies on the market every year to help you make those calls. Long may stock-picking continue to yield profits.

Click here to go to our comprehensive FTSE350 Review page.

For readers viewing this on a mobile please click here to view the sector reviews.

*FTSE classification