Having correctly anticipated the market falls from May 2006, we expected that this was the long awaited correction to the market recovery from the March 2003 lows. Any such recovery is not simply an upward sloping straight line, but rather an upward trend punctuated along the way by shorter periods of falling prices. So if you graph the stockmarkets progress, the uptrend is encapsulated by a series of rising highs and rising lows, and any correction, to be worthy of the name, must break that series of rising highs and rising lows. In this case the index needed to break down through the 5142 low of October 2005.
What actually happened was that the index got down to 5506 in June, and then recovered to now sit above the April peak (which was 6132). So the bull run since March 2003 remains intact, and no true correction has occurred. Should we be worried?
Like Alice in Wonderland, nothing is quite as it seems. As we pointed out previously, the UK stockmarket is now cheaper (in price earnings ratio terms) than it was in 2003, even though the index is now nearly 90% above the 2003 index lows, and this is because corporate profits have increased somewhat faster than the stockmarket.
On the other hand, in April this year we highlighted that the three year long uptrend that we had then enjoyed without a 10% correction was unprecedented since the 1950’s. The fall from the April peak of 6132 may not have breached the uptrend, but it did fall 10.2%, which satisfies those of us fixated on round numbers, though in reality it was not the sharper fall that was needed to make us more confident about the stockmarkets foundation as we move into 2007.
Obviously we can’t have it all our way, and we must accept that bull markets climb a wall of worry, and it has always been so. Being contrarian is not something to be practised every day, otherwise you will be right occasionally, but poor for life. To be successful you need to identify extremes against which to go contrary.
One simple indicator to help identify extremes is how far the index is running above its long term trend, which we define as the 200 day moving average. In April and May this year the index was 10% above this long term trend, and looked vulnerable, though still some way short of the figure of 15% that was more appropriate pre-2000 in identifying extremes. Now the index is 6% above this trend, suggesting there is comfortably headroom for at least 4% to the upside, taking the index towards at least 6500.
In conclusion, there is no need to panic about the UK stockmarket, on the contrary there are some grounds for optimism.