Bill Jamieson: Digging up grounds for optimism – without miners

Published on Sunday 7 September 2008 21:48

HERE we go again. A late summer rally led by banking shares, a flurry of commentary that we may be near the end of the credit crunch, and bang: doom and gloom sets in again - the third false start this year.

Last week the pound sank to its lowest level against the euro and the FTSE 100 index had its worst week in six years, with a fall of almost 7 per cent in the last three trading days to 5,240.7. It has dragged the market back into bear market territory (a fall of 20 per cent or more from the peak).

Now the talk is of the FTSE 100 plunging to 5,000 amid a torrent of poor company results and dividend cuts.

There is no shortage of bad news. And I do not doubt that the economy is going through a miserable time, or that it will get worse. But the danger is that a total surrender to the black mood overlooks the potential for a sharp and sustained recovery in UK shares over the year ahead.

My reasons for optimism for a market recovery before long are threefold.

First, oil prices have fallen back more than 25 per cent from their peak of $147 a barrel in the early summer. This will ease inflation pressures for business and households. And it gives a fillip to the big exporting companies as prices of our goods in overseas markets are that much cheaper.

Second, sterling's value measured against a basket of international currencies is down by more than 20 per cent – greater than the fall that followed the pound's ejection from the Exchange Rate Mechanism in 1992. It was this tumble that marked the start of recovery.

And third, the Bank of England is likely to cut interest rates from the current 5 per cent level over the next two months, and I believe it will keep cutting them through next year. If the recession does prove as severe as many are warning, then rate reductions to 3.5 per cent by the end of next year look quite possible.

None of this will spare UK plc a lot of pain. The headlines will be dominated by closures, failures, cutbacks and dividend reductions if not cancellations.

But that is why many "UK facing" shares have already fallen by 50 per cent and more. The market is a swift and brutal discounting mechanism.

The stock market adjusts, not just for the immediate news, but for its best guess as to what business conditions will be like a year to 18 months ahead. And I would be surprised if conditions will appear as hopeless by then.

Part of the difficulty in reading the market in recent months has been the dominance of mining and natural resources shares in the FTSE 100. I have referred to this problem previously. The continuing boom in natural resources stocks kept the FTSE 100 relatively buoyant. It seemed the impact of the credit crunch on investors was not too severe.

Strip out the miners, and a different view emerges. Shares in many UK-facing companies have suffered badly, particularly in sectors such as house building, construction, retail, financial services, property and UK services.

Now that commodity prices have fallen back, mining shares have been hit, dragging down the FTSE 100. But just as the miners obscured the UK plc picture on the way down, they have also obscured the strength of the bounce.

This "tale of two markets" is well captured in the accompanying chart from Mike Lenhoff, equity strategist at stockbrokers Bell Lawrie.

It shows the FTSE 100 (red line) along with the FTSE 100 excluding resources (black line). The point Lenhoff draws attention to is the apparent breakout – within the rectangle – of the FTSE 100 ex-resources from the downward channel that has been in place for the past year.

Since its closing low of 5,150 in mid-July, the FTSE 100 has rebounded by a little over 9 per cent as of last Wednesday's close, but excluding resources the index was up by nearly 16 per cent. This is a big move and reflects the rotation into the value end of the UK equity market. Sectors that led the way include banks (up 24 per cent), household goods, which includes the house builders (up 23 per cent), general retailers (up 20 per cent), media and real estate (each up 19 per cent), travel & leisure (up 18 per cent) and beverages and pharmaceuticals (both up 17 per cent).

Lenhoff also draws attention to sterling's slide, weaker oil prices and the growing prospect of a cut in interest rates. Sharp falls last Thursday and Friday, reflecting global worries over economic downturn, have darkened the picture but have not, I believe, demolished the underlying argument. Investors will need to be patient, but, given the three developments clearly under way, they should not be panicked out of markets.

How best tactically to handle these volatile conditions? Independent financial adviser Tom Munro has some shrewd advice: retain substantial fixed-interest and cash holdings for now, but feed regular monthly amounts into preferred equity funds. This spreads the timing risks while holding out the prospect of enhanced returns through pound cost averaging (the overall cost of purchases working out at less than the average price).

It seems a sound ploy in these troubled times. Investors need to consider not only the miserable state of markets now but their potential for recovery over the next 18 months.