FTSE 100 reaches critical stage in its battle to beat the bear

After a brief flirtation with bear market territory and a 20% peak-to-trough decline, the FTSE 100 is now rallying, leaving investors to decide whether the worst is behind us or not.

All sorts of behavioural traps and biases lie in wait here, not least as we are all aware that markets have over time tended to go up and that the bear case often looks at its most compelling when the markets face their darkest hours.

Most long-term portfolio builders may well therefore elect to simply sit out the latest round of volatility, stick to their plan and avoid incurring the sort of short-term frictional costs and taxes which can eat away at performance.

Yet any investors looking to take a more tactical view may wish to look at the market with a fresh eye. If history is any guide, then there are three indicators worthy of particular note when it comes to judging whether the FTSE 100 is capable of beating off the bear and advancing once more toward 7,000 or beyond.

They are:

• Technicals. While the column has been trained in the skills of fundamental company analysis and has little truck with the dark arts of chartists, bear markets are typified by a sequence of lower highs and lower lows on a chart. The FTSE 100 needs to pull away from 6,084 and then 6,315 to break this run and give itself a chance of moving to higher ground.
• Volatility. In just 42 trading days this year, the FTSE 100 has risen or fallen by 1% or more from open to close on 27 occasions. Such wild swings are not normally associated will bull markets, where serene progress tends to be the order of the day, so a little calm could be a welcome sign.
• Leadership. The latest rally has been led by the previous cycle’s darlings the miners. For the advance to really convince you want to see a new sector or theme emerging to provide a driving narrative – the mining surge could just be a short squeeze.

If investors feel these signals do start to go the right way, then there is no shortage of means to access UK stocks, more than 85% of whose market cap comes from the FTSE 100. The tables below illustrate the performance of the leading active and passive funds over the past five years.

Best performing UK Large Cap Blend Equity OEICs over the past five years

Source: Morningstar, for UK Large-Cap Blend Equity category. Where more than one class of fund features only the best performer is listed.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Best performing UK equity investment companies over the last five years

Source: Morningstar, The Association of Investment Companies, for the UK All Companies category * Share price. ** Includes performance fee
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Best performing UK Large-Cap Blend Equity ETFs over the past five years

Source: Morningstar, for UK Large-Cap Blend Equity category. Where more than one class of fund features only the best performer is listed.
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Peaks and troughs

One classic feature of any bear market is how an index tends to set a sequence of lower highs and lower lows. The chart below shows how the FTSE 100 has so far followed this pattern since it peaked just ahead of last year’s General Election.

Source: Thomson Reuters Datastream 
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

This is why current market action could be pivotal. The late February rally took the index above its prior closing peak of 6,038 on 22 February, and to where the previous rally had petered out at 6,084 on 29 January.

If the FTSE 100 can make it toward where a rally failed last December at the 6,315 mark then it has a chance of making further progress, if this technical indicator proves a reliable guide.

Equally, an unsuccessful attempt to move sustainably beyond 6,084 and then 6,315 could herald a fresh downturn, even one that stretches toward the 11 February closing low of 5,537, assuming the technicals prove to be any sort of reliable guide.

Swings and roundabouts

Volatility can be a chance to buy assets cheaply or sell them dearly but such wild swings are not normally associated with bull markets where serene progress tends to be the order of the day.

During the bull run years of 2004 to 2006, for example, there were just 12 moves up or down of 2% or more from open to close – and we’ve had that many already in 2016.

The chart below shows the number of 2% daily moves per month and plots those bars against a line which shows the FTSE 100, all the way back to 1995. Again it is noticeable that the index tends to do best on a sustainable basis when all is quiet and trading is not as choppy as it has been of late.

Source: Thomson Reuters Datastream 
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

A more peaceful spring could therefore be a good sign, especially if it coupled with a break-out on the charts, although the reverse could therefore hold true, too.

Leaders and laggards

True bull runs tend to be inspired a fresh, strong narrative. Technology, media and telecoms (TMT) stocks took the FTSE 100 higher during 1998-2000, while financials, real estate and resources stocks spearheaded 2004-2007’s surge. Miners then got a second bite at it as they led the way out of the 2007-2009 bust but since then construction, real estate and consumer discretionary stocks have taken charge as investors have sought out home comforts rather than foreign fields.

Top 10 performing sectors in FTSE All-Share 2011-2015

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

It would therefore be unusual for miners to get a third crack, but they have been instrumental in the FTSE 100’s recovery since mid-February. The table below shows they lie only second to Food & Drug Retailers so far this year.

Top 10 performing sectors in FTSE All-Share in 2016

Source: Thomson Reuters Datastream. 1 January to 29 February 2016. 
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Mining may carry the day, especially as it has been in the doldrums for so long and management teams are responding to the new commodity price environment with dramatic debt and cost-cutting programmes. Yet history would suggest for the FTSE 100 to forge a lasting advance new leadership would be preferable, especially as rallies in former market darlings can turn out to be nasty bear traps.

Just look at how the technology sector fared in the five years after its peak in 2000. This chart shows how there were a number of huge rallies but all of them petered out and made way for fresh downward lurches.

Tech stocks trapped the unwary with several failed rallies as the bubble burst

Source: Thomson Reuters Datastream 
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Compare that to the chart for the miners since their 2011 peak, where five big rallies have already come unstuck. In their defence, the miners have already spent five years in the doghouse.

This is the sixth rally in the Mining sector since the 2011 high

Source: Thomson Reuters Datastream 
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

Price has to be right

If these three pointers start to show signs of encouragement then perhaps the FTSE 100 can cast aside the bear market with which it briefly flirted in February.

Ultimately, however, the valuation at which a security was purchased will go a very long way to determining the return it generates. At least one metric here offers hope the FTSE 100 is in value territory, although it is has it risks.

Regular readers will have seen this graphic before. It compares the yield from the FTSE All-Share with that offered by the 10-year Gilt and measures the difference against the index.

Equity dividend yield from the All-Share is very high relative to 10-year Gilt yield

Source: Thomson Reuters Datastream
NOTE: Past performance is not a guide to future performance and some investments need to be held for the long term.

At the time of writing, equities offer what is a historically very high relative yield, well above 200 basis points (2.0%). On the last two occasions this threshold was reached, 2009 and 2012, the market rallied.

Let’s see what happens this time, with the dangers here being dividends are cut (14 FTSE 100 firms have pruned their payout in the past year) or that gilt yields rise.

Russ Mould
AJ Bell Investment Director