Stockwatch: Why shares remain preferred asset

Is this a "snap-back rally in a bear market" or a bull showing legs? February's dilemma has been a relative pause in company statements between January's pre-close updates and prelims, outlook statements that cluster in March.

Crucially, there have been fewer shock warnings to jolt downgrades, and those companies reporting 2015 results or 2016 outlooks reasonably in line with expectations are seeing their stocks reverse New Year falls. 

A 10% jump in Lloyds Banking Group, declaring a special dividend, shows equities now keenly attuned to dividends; are they poised to grow, be maintained or ultimately get cut in regard to appropriate earnings cover? Lloyds' declaring a strong start to 2016 is also a positive proxy for the UK economy, where it makes the bulk of its profits.

Short-covering a chief reason for rebound

A distraction for investors is the modern extent of algorithmic trading and hedge funds' long/short activity, liable to accentuate momentum trading - for example, last year's sell-off in oil and, more recently, bank shares (amid fears of banks' exposure to the oil industry and China, as well as the impact of negative interest rates on their operations). 

The 25 February equities rally may be a first sign the correlation between equities and oil is breaking downBut these traders are astute not to push a trend too far, given the likelihood for near-term mood shifts. As equities rebounded with oil prices on 12 February, short-covering also encouraged recovery buying, hence a broad markets rebound up to 22 February.

It has coincided also with a sense that oil producers will, in the medium term, co-operate to limit output and stabilise the oil market. Hopes ebb and flow; it's a fluid situation and, with oil markets over-supplied relative to demand, it is tricky to determine if there's a prop. The politics - whether Saudi Arabia, Iran and Russia, for a start, can agree production quotas - are fraught with difficulty.

Double-edged sword of low oil prices

Since the 1960s, recessions have always followed a major rise in oil prices, never a substantial drop like we have seen from over $100 per barrel.

"This time it's different" implies that the stimulation effect of $30 oil on aggregate demand will be overwhelmed by deflation after years of loose monetary policies, created by a dysfunctional financial system rather than any sustainable economic boost. Developing countries, especially commodity producers, are prime-risk, with their high dollar-based debts. 

A chief factor going forward is the reversal in sterling strength, cited by manufacturers as a headwindAlso, more central banks are considering the desperate measure of negative interest rates, thereby undermining banks' operating models.

On such logic, equity values are exposed, given the cyclically-adjusted price/earnings ratio on the S&P 500 index is 24.4, which is 46% higher than the historical mean of 16.7.

Encouragingly for bulls, a 25 February equities rally, despite a circa 1.5% slip in oil prices, may be a first sign the oddly strong correlation between equities and oil is breaking down.  Lloyds' affirming forecasts for over £8 billion underlying profit is also refreshing after Standard Chartered reported a £1.1 billion loss amid challenges in Asia.

Yet the contrast between these two banks' progress shows how sentiment towards equities remains volatile; Standard Chartered being possibly a forewarning of worse to evolve in emerging markets, while the UK is a bright spot globally. But for how long?      

UK economy at risk, yet weaker pound should help

Retail sales, a key indicator for a consumer-driven economy, are lacklustre. While a recovery in January has been cited, a recent survey by the Confederation of British Industry claims they cooled for a second month in February and near-term expectations are at their lowest level since 2013. 

More widely, the industrial sector is challenged. Trifast, a distributor of fasteners that tends to be a useful cyclical bellwether, says this market continues to be challenged, although both mainland Europe and Asia remain strong. That's quite the opposite of what Lloyds and Standard Chartered are saying.

All things considered, the less risky economic future will be seen as the one within the EUA chief factor going forward is the reversal in sterling's strength, which manufacturers have cited as a headwind - the currency is down some 10% versus the US dollar since last year's high - with Brexit fears making any sustained rise unlikely for the next four months. 

Yet this will take time to benefit trading updates and, as a defensive measure, sterling-based investors are favouring shares in global consumer companies such as Reckitt Benckiser Group, which has reported strong results and prospects.

Resilient performance comes at rich equity prices, however, and is why I have recently drawn attention to small-cap Photo-Me International for its improving prospects and three-quarters of revenue abroad.

A disappointing factor is a general lack of director share purchases, although this could relate mainly to closed periods ahead of prelims - or remuneration packages involving so many shares or options nowadays that the executives need not bother with cash purchases. The few which are declared typically involve non-executive directors, who are not part of such schemes.

Brexit fears look overdone

Despite Boris Johnson injecting popular appeal into the "Leave" campaign, I believe (even as a Eurosceptic encouraged by his decision) the UK vote will ultimately be "Remain".

Unless deflationary trends hit company earnings and boards cut payouts, equities are a preferred assetAll things considered, the less risky economic future will be seen as the one within the EU, given the investment from multi-national companies this attracts to the UK, hence jobs security.

When it comes to a trade-off with political sovereignty, the balance of voters will want to avoid pricier imported goods and the pound being worth less for holidaying abroad. 

Scottish opinion also appears significantly in favour of remaining in the EU. What could alter this in favour of "Leave" is the migration crisis worsening significantly again, to turn the public more decisively against open borders. It's also possible that "Leave" votes will benefit demographically from the number of older people who are anti-EU and more likely to turn out on the day.    

Macro and micro essentials favour equities exposure   

Despite the conflicting issues, plenty of dividend yields in the 4-6% region generate support against near-zero or negative returns in risk-free interest rates. So, unless deflationary trends impact on company earnings and boards downgrade payout policies, equities are a preferred asset. Risks in the macro environment can rear up anytime, but the long-term equity bull has legs yet.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.