FTSE 100 is still battling the (long-term, low-growth) bear

The FTSE 100’s brief flirtation with a bear market back in February may seem like a long time ago, as the index stands some 15% above its later winter low, but the UK’s leading benchmark is nevertheless making pretty heavy weather of getting anywhere near the intra-day all-time high of 7,123 set in April 2015.

Now therefore seems a good time to revisit the short-term indicators used by this column before to judge whether the FTSE 100 may be poised to make fresh ground or slide toward this winter’s 5,537 low and bear territory. These three tests 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 hold above 6,084 and then sustainably move beyond 6,315 and 6,444 to give bulls of the index a chance to prevail. This indicator is therefore delicately poised.
• Volatility. There is better news to be had here. After a wild start, when the index rose or fell by 1% or more from open to close on 28 of the first 42 trading days, calm has descended. The next 45 days saw just 11 such movements. This is an encouraging sign as bull markets tend to proceed serenely which bears ones are characterised by sharp, juddering moves lower.
• Leadership. The latest rally has been led by the previous cycle’s darlings the miners. For the advance to really convince you, you want to see a new sector or theme emerging to provide a driving narrative – the mining surge could just be a short squeeze (as for that matter could be the rally seen in the euro, the yen, emerging markets and a whole host of other asset classes which did poorly in 2015).

Highs and lows

The FTSE 100 peaked at 7,123 in April 2015 and troughed 22% lower at 5,537 in February of this year. It then rallied swiftly to 6,410 by 20 April, only to falter again. Investors must now decide this latest down-leg is merely the result of the “Sell in May” seasons trend or a harbinger of something more malign.

The chart – or technical picture – for the market currently offers few clues to this column’s eye, although it must be emphasised this is not home territory to someone who has spent a quarter of a century analysing company cash flows and balance sheets rather than such arcane guides as moving averages, head-and-shoulders formations and Andrews pitchforks.

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.

The FTSE 100 has yet to make a decisive break-out to the upside

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.

Ups and downs

Experienced, patient and risk-tolerant investors will sometimes look to embrace volatility, in the view it can be a chance to buy assets cheaply or sell them dearly. But wild market price swings are not normally associated with bull markets, where steady serene progress tends to be the order of the day, but with bear ones, which tend to be characterised by sharp, juddering drops.

The chart below shows the number of 1% open-to-close daily moves for the FTSE 100 on a monthly basis back to January 2015. It is noticeable that the index tends to do best on a sustainable basis when all is quiet, whereas increases in volatility (as evidenced by the higher red bars) tend to coincide with declines in the index (as well as short-term bottoms).

Volatility has begun to subside after a frenetic start to 2016

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 summer and autumn could therefore be a good sign, especially if it coupled with a break-out on the charts. That said, the reverse could therefore hold true, as well, so a pick-up in volatility and drop below 6,084 would give grounds for concern, as that could mean the spring surge to 6,410 was no more than a classic 15% bear-market rally, of the kind seen six times during the 2000-03 market plunge and seven times during the 2007-09 market downdraft

Winners and losers

True bull runs tend to be inspired a fresh, strong narrative. The Technology, Banks and Mining sectors have all taken the market higher over the last 20 years, across three bull markets, but neither tech nor banks did well in the subsequent upswings – once they fell out of favour they stayed out of favour.

It would therefore be unusual for miners to spearhead a sustained market move higher but they have been instrumental in the FTSE 100’s recovery since mid-February. The table below shows they have led the charge, alongside another fallen commodities hero from 2015, Oil & Gas Producers.

Five Best and Worst Performing Sectors in the FTSE All-Share

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, and the miners have begun to shed some of their gains in recent days, weighed down by fresh doubts over the robustness (and reliability) of Chinese economic data.

Longer-term view

This column is a great believer in the view that you need three things to make a trend so hopefully investors will find study of the three indicators above useful when it comes to their own research and financial decision making.

However, they are essentially tactical, or short-term, in nature and ultimately investing in equities is a long-term game – stocks are like a very high duration bond, as their real value lies in long-term dividends and the cash flow generated to fund them. Any discounted cash flow (DCF) valuation is naturally back-end weighted owing to the terminal value element of the maths.

As such, it may be worth stepping back a little. Yes, the FTSE 100 trades roughly 14% below its all-time high, but it may surprise more than a few when they realise the index trades no higher now than it did in January 2013 – or for that matter in October 2006. That is nearly ten years with only (reinvested) dividend income to show for investors’ troubles and risk-management plans.

And unfortunately it is easy to see why. Markets will respond to short-term noise – the “voting machine” referred to by investment legend Benjamin Graham – but in the end it is cash flow and profits that dictate valuations, or Graham’s “weighing machine”.

This column’s final chart and table could be said to reinforce this view. In 2005, the current FTSE 100 constituent list racked up £127 billion in pre-tax profits between them. In 2015, this figure was £90 billion, thanks to a collapse in earnings from the banking, oil and mining sectors (which shows why they were important on the way up and have been a handicap on the way down).

FTSE 100 firms earned less in 2015 than they did in 2005

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.

The good news is analysts are expecting a huge recovery in profits in 2016 and 2017. The bad is they are always expecting a huge recovery and generally err on the side of (over)optimism – and even if they are right, 2017’s earnings are expected to match 2007, when the FTSE last topped out.

But for now, let us focus on the past as the 10-year compound annual growth rate figures for UK GDP, corporate profits and capital and total returns for the FTSE 100 make for illuminating (if disappointing reading).

Turgid 10-year earnings growth numbers may explain modest capital and total return from stocks

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.

At least when someone says we appear to be stuck in a low-growth, low-inflation, low interest world we now know why, given the torpid rates of progress seen over the last 10 years. While we should never extrapolate from the past or present too freely, if these trends do continue then the importance of reliable income to investors may continue to grow, as total returns have at least outpaced capital ones.

Russ Mould
AJ Bell Investment Director