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Market commentary May 2012

By May 19, 2012No Comments

SUMMARY There is bad news and (for a change) quite a bit of good news. Our analysis suggests that stock markets are about to break down to levels representing significant buying opportunities. Unfolding events in Europe should be the catalyst.

There is bad news, and (prospectively) a fair amount of good news.

Elections in Greece and France have evidenced very sharp swings to extreme parties, and to others that are simply nationalist, with little warmth for the eurozone.  There will be more of the same until a solution to the eurocrisis has been found – and such a solution will, sadly, probably only be born out of a deeper crisis than we have encountered so far.

The immediate problems are

• A re-run of the Greek election is likely next month, and increasingly this looks like it will result in a euro exit
• While Greece isn’t a big issue in its own right, the knock-on effects are a worry e.g. if depositors in Spain and Italy start withdrawing cash from their banks, fearful of those countries leaving the eurozone
• To be clear, if a country leaves the eurozone and re-introduces its old currency, the value of deposits in that new currency will plummet
• French parliamentary elections in June might also see a further swing to right-wing extremists
• Meantime Deloitte refused to sign off the accounts of Spain’s 4th largest bank, triggering fresh concern – it has always been said that Spain is too big to bailout

So let’s look at some bad news, and three lots of good news (for a change!).

The UK stock market right now looks vulnerable.  Our analysis in this respect will never be perfect, but we have always believed we must have a view to enable us to provide appropriate advice.

The UK stock market (FTSE 100 index) is at 5500 as we write, and for most of the last two years has been bouncing around between 5000 and 6000.  We now believe there is a risk it will break down to nearer 4000, most likely triggered by events in Europe.  That’s the bad news.

The first bit of good news is that a rally from these lower levels could take us to new all-time highs, around 7000.  That’s the very good news if it unfolds like this.  Sharp falls allow the necessary “cleansing” which builds the foundation for the next bull market.

The second bit of good news is that individual companies across the US and UK, Europe and Asia are sitting on record amounts of cash.  This is because for much of the last 10 years they were reducing debt, and from 2008 many companies improved profitability by laying off staff.

This means that the bonds issued by UK businesses are a much safer bet than those of many highly indebted countries.  In a very low interest rate environment, bond funds with yields of around 4% (and higher) are very attractive.  For example, the M&G Corporate Bond fund has a yield of 3.8% gross, and the total return over the last year (income plus capital growth) was 8.7%.

So corporate bond funds will provide a lot of protection as the stock market falls, and then from the lows we can switch into “cheap” stock market-linked funds.

The third piece of good news is the potential within the stock market from those lower levels.  One angle we often talk about – dividends.  A company sitting on cash is clearly more capable of increasing its dividend payout, which is vital through a long retirement.  And if the UK stock market fell by as much as we suggest above, the dividend yield rises to 4.8%, and somewhat more for specialist equity income funds.  Another angle is that share prices amongst smaller companies are being buoyed by increasing takeover activity – smaller company funds will be on our shopping list when markets head lower.

As ever we stress that all of the above represents just one possible outcome – but it is one which we believe is becoming increasingly likely.  We will stay in touch as events unfold, including if something markedly different occurs. 

Dennehy Wealth