Early in 2010, I wrote a piece looking at a number of experts' stock market predictions for the year – and what a fantastic display of fence-sitting we saw. On average, the prediction for the FTSE 100 was that it would go precisely nowhere in 2010 and finish the year where it started. As it turned out, that hasn't been too far from the truth. Investors' moods have swung between nervousness and ebullience, with every two steps forward the market has taken followed quickly by two back.
"An extraordinary year," says Jeremy Batstone-Carr, head of research at broker Charles Stanley, which has seen, as he points out, two mini-bull markets (January to April and July to November) and one-mini-bear market (April to June). Investors' risk appetites swung wildly between extreme caution and extreme recklessness throughout the year, resulting in what Richard Buxton, head of UK equities at Schroders, describes as "whipsaw volatility".
But the volatility is just one distinguishing feature of 2010. To my mind, one of the most extraordinary features of the year has been the difference in performance between large and not-quite-so-large companies. Take the first half of the year, during which the FTSE All-Share fell 11 per cent, even after a storming start. Surprisingly, it was the blue-chip index that led the decline, dropping 13 per cent over the period, more than double the decline in the FTSE 250, which fell 5 per cent.
I say surprisingly, because the differential performance confounded the expectations of most equity market strategists. A quick recap of our stock market review last year reminds us that many predicted that a stuttering economic recovery in the UK would hit FTSE 250 companies hardest, given their greater domestic exposure, and expressed the belief that, as the slowest major economy to return to growth after the credit crunch, the UK economy was structurally damaged. Large multinational blue-chips were the place to be, they said, given that overseas economies, and particularly emerging markets, would offer much better growth prospects.
That's partly because the economic trauma that had been expected to batter the UK simply did not materialise. "The UK could have become a fiscal victim in 2010 but has been an outperformer," says Philip Isherwood at Evolution Securities. In fact, the Office of Budget Responsibility recently upped its forecast for UK gross domestic product (GDP) growth in 2010 from 1.2 per cent to 1.8 per cent, although it and other forecasters including the British Chamber of Commerce have marginally pared back expectations for 2011. "It is a paradox that the worst recession of a generation has made the UK one of the most attractive areas for investors today," says Mr Buxton.
But the UK's surprising strength is only part of the story. Europe's sovereign debt crisis also exposed a tangled financial web that reminded us that international exposure was no guarantee of security. 'Contagion' became the word of the hour (swiftly followed by 'austerity', as governments woke up to the realisation that its deficits were unsustainable). Even China’s seemingly unstoppable growth prospects were called into question – as well as the prospect of weakness across its major trading partners, China itself appeared keen to tighten its monetary policy to prevent the possibility of its economy overheating.
In the first half of the year that meant commodity prices suffered too – bad news for the resource stocks that make up such a large proportion of the FTSE. Between mid-April and June, commodity prices slumped by 25 to 30 per cent, which hit the FTSE's many large mining companies. To compound it all, BP's Gulf of Mexico disaster saw its share price plunge – and, given that the group accounts for such a large proportion of the UK index, its bad luck dragged the rest of the market down with it.
But just as BP's well was eventually capped, so was the gusher of negative sentiment that saw use of the expression 'double-dip recession' gather momentum throughout the summer. Government intervention, first in the form of a collective bailout of Europe's problem child, Greece, and latterly in the form of the US government's second round of quantitative easing (QE2), once again meant that economic catastrophe was avoided and deflation averted, prompting a meteoric rise in markets around the world and helping all-important commodity prices recover lost ground, and more. Exactly six months into the year, the FTSE began a storming recovery that saw the All-Share gain nearly 19 per cent in the second half, with both large and mid-cap indices enjoying a similar level of upside.
Of course, this pattern isn't just a UK phenomenon – most major indices have moved largely in tandem this year, all in thrall to the ebb and flow of global economic data and events. What happens in the US, Japan, or China is crucially important to the returns we can expect from the UK markets. The picture is now more global than ever.
A global economic tsunami?
That makes predicting what will happen on the markets this year more difficult than ever before. The butterfly's wings that can lead to a global economic tsunami could flap anywhere – we have already witnessed how small and seemingly insignificant economies can create a domino effect that wreaks havoc around the globe. The latest casualty, Ireland, once the poster-child of European economic advancement, now needs propping up to the tune of E85bn (£71.29bn), subsumed by monstrous debts that even a deep austerity programme couldn't address. It's another blow for UK banks, which have large property exposure there, and for UK taxpayers, who will be picking up a large chunk of the bill while having to endure austerity cutbacks of their own in the coming year.
But so what? The world is more connected than ever, yet sometimes strangely disconnected – investors have been quite ready to jump into risky assets at the first hint of clearer skies, without paying much attention to the storms predicted by the long-range weather forecast. Who cares if asset prices are being propped up by huge US money printing – the fact that they are being propped up is the only thing that matters.
A resolution to the current sovereign debt crisis raging across Europe would be a fillip to share prices, even if, like QE2, it is merely kicking a fundamental problem down the road. That said, as Jeremy Batstone-Carr at Charles Stanley, notes: "One does not solve a debt crisis by adding more debt... contagion fears are likely to remain a feature of the investing backdrop in 2011".
So, while the problem appears to have been bottled for now, and is underpinning a traditional rally, 2011 could just as easily see further leakage and a sustained bout of equity market weakness.
Or a bullish outlook
Even so, in the UK there nonetheless remains a surprisingly optimistic prevailing view among company management and market analysts, despite an overarching environment of frugality. Consumers continue to score lowly in confidence surveys, but keep on spending – November data from research companies GfK/NoP showed UK confidence at its lowest level for 18 months, yet the Confederation for British Industry's (CBI) distributive trades survey suggests retailers are largely optimistic. And companies continue to report rising earnings, with the number beating expectations at its highest level for several years.
Admittedly, though, much of the earnings outperformance hasn't been driven by organic sales improvement – cost-cutting has been crucial, and steady deleveraging throughout the year has added another boost to earnings in the form of lower financing costs. Management has also learned not to push expectations too high – in an environment where nerves are still jangled, it’s better to be cautious and beat forecasts than set yourself up for a fall.
The downturn has also given companies a great opportunity to get themselves down to the financial gym, toning up operations to be more efficient and consume less working capital. The result has been further acceleration of debt reduction, particularly among companies outside the blue-chip index that would otherwise have been forced to stomach higher borrowing costs.
Less debt and strong cash generation could also mean higher dividends, with companies looking for ways to distribute surplus free cash – although some of that is likely to be diverted to capital expenditure after companies scaled back investment in 2010. Certainly, after a torrid year for income seekers, which saw bond yields hit record lows and aggregate dividend income hit by the BP disaster, payouts have started to rise again.
That's an attraction that could once again attract investors to blue-chip shares. And, although equity strategist Gerard Lane at Shore Capital is mindful that the main risk to the valuation case for equities in 2011 is higher bond yields, Mr Buxton at Schroders believes that "even if bond yields were to drift up next year, it would not undermine the valuation of equities because those yields are held artificially low by monetary policy".
And while the fact that UK equities are generally in good shape hasn't gone unrecognised by the market, with UK equities within spitting distance of the all-time high reached in October 2007, it is the blue-chip index that appears to offer the best value as we head into the new year.
The FTSE 250's remarkable 16.8 per cent gain by mid-November this year – the best performance by any major index – has disguised muted earnings growth of around 10 per cent, and has left the mid-cap index looking aggressively valued, on a 2010 PE ratio of 14 and yielding a meagre 2.7 per cent. It will need to pull some seriously impressive earnings growth out of the hat next year if it is to repeat its outperformance – simply hitting the 20.1 per cent consensus expectation for earnings growth may not be enough, although that's admittedly higher than the 16.5 per cent expectation for the FTSE 100.
Playing it safe
That said, the FTSE 100 is still over 1,000 points lower than its 2007 high, which leaves it trading on a much more modest 12.5 times earnings, and yields 3 per cent, even after raising earnings by a whopping 56.4 per cent this year. Partly that reflects recovery, partly it's down to cost-cutting on a gargantuan scale. But it is also the result of the greater emerging markets exposure analysts were so keen on last year – and the FTSE 100 remains a low-risk proxy for global growth. But Mr Batstone-Carr adds a note of caution: "At present the benign consensus seems to be that western developed economies will muddle through and that Asian economic activity will remain robust. We suggest that investors be far less sanguine".
And therein lies the issue – that it is virtually impossible to predict what will happen this year, given the confusing tangle of influences that are at work and the potential for unknown unknowns such as BP's Macondo well to wreak havoc with markets again. But with such uncertainty one surefire bet is that we are likely to see the same rollercoaster ride in 2011 as we did last year, and many investors will be playing it safe and sticking to defensive, income bearing equities this year.
