So many pundits are now concerned that the FTSE is ‘rolling over’.
I know, that’s a bit jargony – but it just means that many of them think that the market has peaked, and is in the process of coming down in a big way.
And if you’re an investor with ‘skin in the game’, the question is a big one: is the FTSE on another plunge to the bottom of its trading range, soon to be followed by the usual bounce back?
Well, we’ve definitely dropped through the bottom of our trading range. If you look inside the red circle on the chart below, you can see that the market has broken through the lower Bollinger band (my favourite way of timing good entry and exit points into the market).
What’s next for the FTSE?
(As a side note, you can customise your own charts of the FTSE 100.)
Is this a danger sign?
Investors are worried about the FTSE – and it’s not just down to geopolitical events, or a slowdown in China either.
But we’ve also got the more prosaic stuff, like over-hyped stock flotations (eg, Alibaba), or the many leveraged buyouts (when a company is bought out using huge amounts of borrowed money), and even tales of bankers’ excessive bar tabs in fancy London restaurants.
And yes, I accept that these are all things that offer clues to an overheated market – just as the ratios suggest.
But here’s something to think about: what if the issue with with p/e ratios is not the price (p), but their earnings (e)?
What if it’s not that these anecdotes and metrics indicate a market that’s out of whack, so much as the very thing used to measure them?
Maybe we’re looking at this all wrong
Now, when it comes to valuation multiples like p/e ratios, a correction can come in two ways.
First, clearly a slump in the stock price, but a p/e ratio is not simply a function of price; a rise in earnings could also restore balance.
I freely accept that today’s world isn’t one in which we see company earnings storming ahead. But in an inflationary world, that’s exactly what’s likely happen (I’ll explain how in a moment).
And what with the Bank of England’s constant procrastination on quelling loose monetary policy, and the fact that central banks the world over are increasingly using some form of QE (quantitative easing) to bolster economies, shouldn’t we be preparing for inflation? I mean, with more money circulating, prices must go up eventually.
Think about it – the planners have pumped hundreds of billions of pounds into the financial and housing markets. Not just in QE form, but also in loans and other stimulatory packages.
And, so far, the money has stayed in those places. That’s precisely why metrics like p/e fly.
But that could all change.
This could send the FTSE to new highs
As I’ve mentioned, there’s precious little to stop all this money flowing out into the real economy.
And what does that mean? Inflation. Inflation could start creeping back quickly as bondholders dump, seeking solace in inflation-protected holdings, be they in the financial markets, or outside of them. Stocks have always provided an element of inflation protection that bonds simply can’t provide.
By the way, it may surprise you to learn that the bond market is many times the size of the equity markets. It is certainly no idle threat that inflation could cause a substantial flow from the former to the latter.
Anyway, the point is that with inflation on the cards, we could see an earnings pick-up for corporations.
Here’s a little example just to illustrate the point:
If Company A is currently making £100m on £1bn turnover, it might well be expected to make £200m if turnover is inflated £2bn. Assuming the business maintains margins, earnings are double, that means the p/e multiple is slashed in half.
That’s why stocks can do very well during times of inflation.
So, here’s the key question: is the market pricing in inflation or is it simply high on artificial steroids – and therefore primed for heavy falls?
Get used to the status quo – and use market downdrafts to top up
It strikes me that the status quo of recent years is the most likely scenario. Though the stockmarket trades near its highs, what we’re witnessing is neither dotcom mania, nor a subprime-like banking top.
Today, stock prices reflect the poor returns from competing investment classes – especially its big brother, the bond market. And, it could well be a reflection of inflation fears too.
And there’s nothing on the horizon that looks like changing this fundamental premise. If that’s the case, how should you invest?
Well, I personally continue to use market downdrafts to top up my holdings.
Keep in mind that inflation could be the game changer here. Over the medium to long term, it could even bring valuation multiples back into line with historic norms – even without a crash!
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