Does one chase this market into the mist and mellow fruitfulness of September or are most of the blackberries gone leaving only the thorns?
According to the FTSE Actuaries Share Indices published by the Financial Times last week, the FTSE100 Index was valued at nearly forty times earnings and on a dividend yield of 3.7 percent; clearly showing that the big market cap, publicly quoted companies – largely internationally trading – were on average, paying dividends out of capital not from reported statutory earnings. Roughly speaking, the “earnings” yield on that basis is about 2.5 percent; self evidently inadequate to cover a dividend yield of 3.7 percent. The valuation measures for the UK oriented FTSE350 Index were a price earnings ratio of 34 times (an earnings yield of some 3 percent) and a dividend yield of 3.5 percent.
Naturally, this does not reflect the ‘adjusted’ and ‘underlying’ earnings of companies, with which we are now long familiar and which need to be taken into account when making judgements about the central ongoing ‘core’ of business activity.
One of the important differences between equity investment and bond investment is that the latter is a hostage to fortune whereas the former is a pro-active responder to it by changing business models to adapt to rapidly changing circumstances. If a subsidiary company that is performing less well is sold, then investors need to know what that will mean in terms of earnings growth, dividends and cash flow etcetera.
Moreover, we need to be able to compare the profit and earnings performance of a particular company in relation to the previous year and in relation to next year and the year after that! If there is management progress, then we need to have it spelt out as clearly as possible. That is the purpose of adjusted, underlying estimates of profits and earnings.
Investors need to understand when and what assets and profit streams are sold off and deconsolidated. The bald, ‘matter of fact’, reported figures which are the basis of indices, leave that out to show the statutory position. That too is part of the market risk measure of investing.
So, high index valuations like these should prompt us to question the extent of the margin of risk that investors are taking on board. There are clearly a lot of things that a numerous companies have got to get right to judge by these highly rated indices. There is also the bullish assumption about coming trading conditions, implied by Index ratings. A market selling on 33 to 40 times earnings is in principle dear by discounting progress. That should prompt us to question individual share valuations stringently. Moreover, it currently gives credence to chart reads, suggesting that the FTSE100 Index looks ready for a correction.
This is performing well but it has been heavily dependent on consumer spending because corporate investment has been low. UK consumers have been putting a lot of purchases on credit cards. They are highly borrowed and are not, according to the latest figures, paying off debt. How long can that go on? And what happens when the Brexit devaluation of sterling starts to increase consumer price inflation later this year and early next year. It could be very painful, dispelling the mellow mood of current consumer confidence. It is that, which is central to the belief that UK economic activity will falter this winter, leading a recession or near recessions in UK GDP. However, we define it, ‘recession’ or ‘slow down,’ consumer demand will certainly fall this winter as rising import prices outpace increases in salaries, wages and ‘take home’ pay.
This has been brought about by the near desperate monetary policy of the Bank of England to halve interest rate costs too a low breathing 0.25 percent per annum, in anticipation of the arrival of import lead inflation, after foreign holders of sterling dumped the currency after the pro Brexit vote. Congenital critics of central banks may bang on about low interest rates (the ‘liquidity trap’ of which Mr. J.M Keynes advised us some seventy years ago) but the simple fact is, that the UK Treasury under Mr. Osborne’s policy , left the bank with no other option by refusing too little help by way of ‘fiscal’ economic stimulation measures. That will clearly need to change. One of the forward relatively bullish signs is that Mrs. May’s government is already taking that option by increasing levels of unfunded spending to keep demand going.
Rather tiresomely, politicians and newspapers which supported the vote leave campaign, are rushing to claim the latest economic results prove them right. If Mr. Osborne had remained, it is possible that we could have seen interest rates rise to defend the pound, by keeping ‘hot’ money in Britain to balance the books, as overseas holders dumped it on the way to the exit doors. Much of the better than expected economic data in the last few weeks is due in a part to the discontinuation of the Osborne policy; the reassurance role of the Governor of the Bank of England in slashing borrowing costs and; clear indications from a seemingly more pragmatic May administration to step in to keep economic demand going if required at a crucial time with the shrinking of the consumer real incomes (I hear no one denying that prospect) as a result of the Brexit referendum vote.
That leaves more hopeful uncertainty in the UK but uncertainty none the less. To that, we must add uncertainty about the UK maintaining tariff free access to the EU trading bloc. Despite its constitutional imperfections, the EU remains the largest and most prosperous – even now – market in the world. For foreign long term real capital forming investors like the Japanese, it is important that the UK remains geared to that.