Equity Market Rally - "Will there be a sting in the tail?"

The pace of equity market decline accelerated in February 2009, with the FTSE100 index falling from 4295.20 on 28 January 2009 to 3,512.10 on 03 March 2009, with markets falling on fears that the global banking sector would collapse. The multi-billion /$ bail-out packages and quantitative easing programmes that followed in the UK, allayed these fears and some rationality returned to the markets. Since then, equity markets have surged, albeit with some volatility, to their current levels.

The FTSE 100 index, for example, rose from 3,512.10 on 03 March 2009 to 4,908.90 on 28 August 2009, a rise of virtually 40%; one of the sharpest short-term rallies for many years.  But, what spurred this remarkable about-turn and, more importantly, what has sustained it?

The original relief after the global financial collapse had been averted was tangible.  Also, a number of positive growth outlooks from Central Banks and eminent research organisations added weight to the upward momentum. A better-than- expected second quarter earnings season (particularly amongst Banks) and reports that several countries had emerged from official recession (France, Germany & Japan), certainly started (and kept) the ball rolling (Source: TAM Asset Management, August 2009).

Intriguingly, however, the most recent driver appears to be fear! This fear derived from the fact that investors, who had reduced equity exposures in the fourth quarter of last year (and even more unfortunately the first quarter of this year), felt they were missing out. The higher the market climbs, the harder it becomes for these investors to retain their conviction and stay out of the market and so fear spreads! Their subsequent capitulation led to the surge of money invested that kept markets rising throughout July and August.

Is this a broadly-based rally?  The rally was driven by a select number of cyclical sectors, including Banks, Mining and Metals, which all significantly outpaced the Index. This was in contrast to defensive sectors, Utilities, Consumer staples, Healthcare and Pharmaceuticals, which lagged (or even fell) during the rally. It is certainly significant that investors favoured companies with historically volatile share prices and higher earnings growth expectations and ignored profitable companies with stable cash flows and high dividends.

With better than expected second quarter earnings results this had the effect of reassuring investors and helping boost the market. However, a more worrying trend emerges when one looks at how companies increased profitability.  The improvement relied heavily on cost-cutting' rather than 'revenue growth' as witnessed by the thousands of redundancies announced. Unless economic growth is actually increasing, it could be more difficult for companies to increase earnings during the current quarter!

Economic fundamentals appear to remain weak. Unemployment jumped by 220,000 in the three months to June 2009 to 2.435 million, the highest level since 1995 (Source: Guardian 12 August 2009). More worryingly, it is also forecast to rise above three million by next year.

Taking all of this into consideration there are some strong signals to suggest that further returns are likely to be harder to obtain in the equity markets over the next few months.  Certainly, for those investors who joined the rally late, there could well be “a sting in the tail” as markets remain volatile.

So, in conclusion, it is important that we remind ourselves that equity investments are for the longer term investor and, as such, we remain confident about the ability of the Stockmarket to provide above- inflation returns over the medium to longer term.  Investors are still likely to experience short-term volatility, including the occasional sharp correction en route to their goal.

Whilst not resisting the worst of the falls, actively managed, multi-asset portfolios have helped our clients 'weather the storm' and to participate in the recovery.  Consequently, we remain committed to this philosophy and will continue to recommend this to existing and new clients alike.

Investors should be aware that prices may fall as well as rise and that the income derived can go down as well as up. When buying or selling any investment that fluctuates in price or value, you may get back less than you invested. Past performance is not necessarily a guide to future performance. The value of investments denominated in foreign currency may fall as a result of exchange rate movements. Any investments and services referred to in this article may not be suitable for all investors and you should seek advice before committing to any course of action.

Any opinions, expectations and projections within this article are entirely those of the author and represent only one possible outcome.  Information contained in this article is not recommendations.