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Does the FTSE 100 Tumble Present a Buying Opportunity or Is It a Falling Knife?

May 11, 2012 | About:

Given that the FTSE 100 is trading as weakly as we've seen it since last year's trade off, it's a pretty opportune moment to reflect on the first third of the year. I wrote an article early in January that laid out my own thinking on the state of the market where I had mused on the possibility of a short term relief rally driven several factors - the excessively bearish sentiment at the time, dovish monetary conditions and technically bullish profit margin signals. The first 3 months of the year offered up sizeable gains for nimble investors - with at least a 10% rise in the FTSE 100 on top of the gains in December, but the last 6 weeks have given all those gains back. Pretty frustrating to say the least. But there were and still are plenty reasons to be more bearish in the medium to long term, and on top of that with macro concerns consistently flaring up and bankers continuing to show their ineptitude the downside heat is growing. Lets take a look at a few factors.


Now I know plenty in the community around Stockopedia who aren't minded to enjoy discussing anything related to technical analysis, but the reality is that momentum works - it's been proven in the lab and in the wild to be a persistent anomaly and made many many hedge funds and traders millions. Just look to the work of Josef Lakonishok or others for the proof in the pudding.

While most of us can't run sophisticated algorithms, we can 'parse' simple visual cues more easily. The 200 day MA is probably the best eyeball of market 'trend' that there is, and its displaying a nasty increasingly downward slope. Worse than that, the FTSE 100 has just cut through the 200 day Moving average on the downside. There are all kinds of strategies that hedge funds play off the back of various moving average timing signals, and this is a classic signal and a portent of building sell pressure. On the other hand many use the 200 day MA as a 'support' level and buy aggressively when stocks reach it. Whichever way the market moves from here it's probably going to move quickly.


Profits Margins

To add to the portent, there was a terrific article by James Montier recently (titled "What Goes up must come down") which cautioned that profit margins are at completely unsustainable levels. Given that the stock market is primarily driven by earnings expectations his paper holds out some frightening ideas for investors. He explains that the majority of US corporate profit growth has been driven by government spending / deficits. Check out the growing proportion of margins that are driven by government spending in the image below. The red section of the chart has grown to its largest proportion of margins in history. This just can't be sustained. A 'reversion to the mean' can only be expected at some point - and unless net investment ticks back up to typical levels stock market investors could be in for a rude awakening.



But on a more dovish note I noticed a good post by UK Value Investor earlier this year with a nice image of the FTSE compared with its long term cyclically adjusted PE ratio (CAPE). The CAPE has been popularized in recent years as its been shown to be very predictive of longer term returns in the market - it calculates the PE ratio not with current earnings but with the average of the previous 10 year's earnings. This supposedly gives a more realistic PE ratio for the market as it smooths out the bumps across multiple business cycles. Clearly, from the image below, at a level of 5450 the FTSE is moving into the 'cheap' territory - and by his reckoning 7 year forecast returns at this level are around 10% per annum which would be a nice return. Given the macro environment though, I think that number could well be optimistic but certainly the UK CAPE is starting to back up the arguments of others (such as the dividend discount model created by Glenn Martin) which also states the market is at a big discount to it's intrinsic valuation. On the other hand that's certainly not the case in the US where the CAPE is at a big premium to its long run average. As the US tends to lead, while the rest follows, the UK CAPE may not be as meaningful as we might like it to be.


What's your take?

With Europe falling apart at the seams, austerity ruling, and no signs of growth in many western economies it's not exactly an environment where investors are going to be rushing out to buy stocks in spite of the fact that interest rates are at ridiculously low levels and they have little other opportunity. In fact the ongoing volatility and bearishness of the environment is prompting more and more investors to keep withdrawing money from funds for the supposed safety of cash. This kind of environment leads me to expect that at some point over the next 12 months we may well see even lower lows in many of the best stocks in the market regardless of whether that comes to light at the index level. Many in the market are looking to Ben Bernanke as their best hope of pulling the stock market out of this mess - can QE3 come to the rescue or are investors too tired to respond to yet more pushing on a string?

Regardless, in the history of the stock market it's always been the contrarians who have won - the key is to be able to take advantage of individual stock dislocations by holding back some cash at the ready and acting decisively when opportunity presents itself. There are bags of great companies out there in the market, generating cash and growing on the individual level and the macro environment will continue to serve up opportunities to pick up stocks on the cheap. This is a stock picker's market and personally I am in no rush - what's your take?

About the author:

I'm a financial journalist with a Master of Science in journalism from Medill at Northwestern University.

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