Market view

The three months to the end of June were was one of the best quarters enjoyed by the stock market for many years but in June itself the market did a bit of a Henman: it promised much but delivered very little when it really mattered.

The FTSE 100 index fell by 2.38 per cent between 2 June and 30th to close the month at 4,031.17. Chartists claimed that the failure to stay above 4,200 for more than one day meant that the post-Iraq rally had met its resistance level. Fundamentalists point to the weakness of oil stocks, pharmaceuticals and profits-taking in Vodafone as the key to the slippage since together BP, Shell, GlaxoSmithKline, AstraZeneca and Vodafone account for around a third of the FTSE 100 by weighting.

The FTSE 250 index is, of course, less exposed to big oil, pharma and telecoms stocks and hence it actually gained ground on the month, ending June at 4,963.44 – a net gain of 1.71 per cent. And it was the cyclical sectors such as Auto and General Retailers that led the second liners higher on the basis that more interest rate cuts were in the pipeline and that just has to prompt an earnings recovery next year.

But the stars of the show in June were the small caps. The FTSE AIM index managed a gain of 3.91 per cent to reach 641.41. Arguably, the end of any rally is always marked by a last splurge of buying of less liquid assets which therefore jump disproportionately in value.

Year of the bull?
The second quarter of 2003 was a glorious one. The FTSE 100 managed a gain of around 25 per cent and some were even suggesting that a new bull market was underway. Others argued that this was all bull and that what we were seeing was nothing more than a very large example of the savage rallies that periodically occur during a prolonged bear market.

Among my colleagues at t1ps.com, one (the trading psychologist John Piper) has a target of 1,000 for the FTSE 100 while another (small-cap guru Mark Watson Mitchell) sees the Footsie hitting 5,000 by Christmas and 6,000 during 2004. Arguably they could – just conceivably – both be correct but it seems unlikely. It just goes to show that the more experts you consult the more (differing) opinions you get.

The bull case is pretty simple. It argues that although economic data in both the UK and US is mixed there are tentative signs of economic recovery coming through (more so in the US than over here). Moreover interest rate cuts already made take some time to filter through and so that should boost growth as should the relative weakening of both the dollar and sterling against other major currencies. Bulls also argue that on both sides of the Pond (but especially in the UK) there is still scope for more cuts in base rates (some economists reckon that by Christmas UK base rates will be down by 75 basis points to 3 per cent) to pep up growth should it start to falter.

Extreme bear
The extreme bear case is that the issue is not one of flagging growth but one of fighting off the global threat of deflation. The principal source of that deflation is China, which has continued to undercut most Western producers and so ‘export’ its lower costs. However, a number of first world economies (notably Germany) are now suffering recessions which could well turn into a deflationary spiral where asset prices fall continuously and, critically, consumers expect this to be the norm. Japan has of course been suffering deflation for more than a decade although there are, perhaps, glimmers of light at the end of that particular tunnel.

The extreme bear therefore believes that it does not really matter how much base rates are cut, the medicine has not worked so far, so why should it work now? For those in this camp the only possible outcome is that corporate earnings, instead of recovering, will actually decline over the next few years. If that is indeed the case then the FTSE 100 – on a PE of around 16 – looks pretty exposed and US markets (on almost twice the rating of London) are a straight one-way bet.

There is a lesser bear case. And that is based simply on valuation. Typically at the end of bear markets major indices trade on very high single figure PE ratios. Even at 3,300 the FTSE 100 was on a PE of 12. The minor bear might therefore argue that we have yet to see the final sell-off and capitulation that historically marks the end of a bear market.

The lesser bear might admit that the US and UK economies should avoid being sucked into the economic quagmire that is the eurozone. That is because, whilst the eurozone is cursed by rigid institutional monetary and fiscal impediments to stimulating economic growth, that is not the case in the UK or US. Moreover the ‘independent’ economies also implemented drastic supply side reforms in the 1980s, which enabled them to adapt and compete on a global scale. Europe did not.

However the problems of the eurozone and high levels of corporate and consumer debt in both the US and the UK are likely to act as a drag on growth - as is the UK’s ever-increasing tax burden. And hence the minor bear can argue that if the prospects are for pretty sluggish growth in earnings, a PE of 16 for the FTSE 100 looks pretty full.

Moreover the minor bear might add that UK PLC has gearing of around 40 per cent and dividend cover of just 1.6 times. Given that free cashflow from operations looks unlikely to rise dramatically and that for many companies the priorities will be to reduce borrowings, increase dividend cover to at least two times and – perhaps – even to restart long-neglected capital investment programmes, it is hard to see how shareholders can enjoy much medium term upside on the dividend front. The minor bear may not predict a dramatic crash but he can make a pretty solid case against the UK being on the verge of a new bull market.

Tom Winnifrith edits the financial website www.t1ps.com

OTHER TABLES IN MY SHARED FILE

FTSE 100 INDEX

Stock	1 month	Rank	1 year	Rank
3i Group Inv Tr	97.41	65	83.68	66
Abbey National	93.17	89	63.58	92
Alliance & Leicester	99.52	47	105.06	17
Alliance Unichem	99.5	48	82.68	69
Allied Domecq	97.65	62	80.51	74
Amersham	97.17	67	79.71	76
Amvescap	112.82	3	80.76	73
Anglo American	97.88	59	88.1	52
Associated British Foods	94.04	85	91.91	43
Astrazeneca	98.26	58	92.5	41
Aviva	94.55	82	81.72	72
BAA	103.1	24	84.96	60
BAE Systems	110.04	7	45.27	97
Barclays	104.65	21	85.53	58
BG Group	99.17	51	95.21	35
BHP Billiton	101.34	31	92.03	42
BOC Group	101.11	34	79.48	77
Boots Group	107.55	12	104.52	18
BP	100.54	41	79.82	75
Bradford & Bingley Ord	90.11	95	98.6	28
British American Tobacco	104.88	20	102.99	21
British Land	99.9	45	88.61	51
British Sky Broadcasting	101.28	32	106.76	14
BT Group	105.84	17	82.67	70
Bunzl	94.39	83	83.92	63
Cable & Wireless	110.24	5	70.62	87
Cadbury Schweppes	100.85	36	75.21	82
Canary Wharf Group	142.22	1	69.27	88
Centrica	98.87	53	88.65	50
Compass	97.83	61	84.17	62
Daily Mail & General TA N/Vtg
Diageo	98.78	54	78.57	78
Dixons Group	114.29	2	72.06	85
EMAP	100.06	43	107.32	13
Exel	92.97	90	77.33	79
F&C Investment Tr	101.6	27	86.33	56
Friends Provident	97.84	60	84.26	61
Gallaher Group	96.83	70	101.12	23
GKN	108.54	8	77.03	80
GlaxoSmithKline	101.49	29	89.14	49
Granada	102.82	25	83.82	65
GUS	108.08	10	117.67	4
Hanson	95.68	78	75.34	81
HBOS	110.18	6	115.9	5
Hilton Group	107.76	11	85.35	59
HSBC Hldgs	99.31	49	99.51	26
Imperial Chemical Industries	90.26	94	40.1	98
Imperial Tobacco	98.45	56	105.09	16
Johnson Matthey	102.49	26	89.68	48
Kelda Group	98.62	55	106.49	15
Kingfisher	108.41	9	91.47	45
Land Securities	98.98	52	93.47	39
Legal & General	97.39	66	68.07	90
Liberty International	96.8	71	110.57	9
Lloyds TSB Group	96.15	74	71.67	86
Man Group	96.85	68	118.54	3
Marks & Spencer	110.4	4	87.57	53
MM02	92.28	92	135.12	1
Morrison (Wm) Supermarkets	96.08	75	91.81	44
National Grid Transco	104.18	22	90.44	47
Next	106.37	16	113.72	7
Northern Rock	92.6	91	107.66	12
Old Mutual	100	44	99.13	27
Pearson	99.3	50	91.04	46
Provident Financial	101.43	30	97.19	30
Prudential	96.58	72	65.44	91
Reckitt Benckiser	93.52	88	96.74	33
Reed Elsvier	100.65	40	82.71	68
Rentokil	105.14	19	73.2	84
Reuters Group	96.83	69	54.51	95
REXAM	100.53	42	93.37	40
Rio Tinto (Reg)	95.32	79	97.97	29
Rolls Royce Group PLC	103.64	23	86.47	55
Royal & Sun Alliance	97.54	64	60.9	94
Royal Bank of Scotland	107.26	14	94.47	37
Sabmiller	100.68	39	82.15	71
Safeway	95.81	77	93.59	38
Sage Group	101.09	35	96.91	31
Sainsbury (J)	93.81	87	74.37	83
Schroders	93.85	86	108.8	11
Schroders Non Vtg	90.78	93	100.05	25
Scottish & Newcastle	95.82	76	62.78	93
Scottish & Southern Energy	98.35	57	101.17	22
Scottish Power	100.83	37	111.67	8
Severn Trent	95.14	80	100.98	24
Shell Transport & Trading (Reg)	99.75	46	83.89	64
Shire Pharmaceutical Group	96.5	73	68.97	89
Smith & Nephew	94.12	84	96.82	32
Smiths Group	105.4	18	85.6	57
Standard Chartered	100.75	38	109.68	10
Tesco	107.34	13	94.89	36
Tomkins	94.58	81	96.55	34
Unilever	88.69	98	82.92	67
United Utilities	101.2	33	104.23	20
Vodafone Group	90.04	97	133.44	2
Whitbread	107.11	15	114.3	6
Wolseley	101.55	28	104.33	19
WPP Group	97.64	63	86.68	54
Xstrata	90.04	96	48.45	96
Total Average (100)	100.17	100	89.36	100