Interactive Investor

Where's the FTSE 100 off to next?

15th September 2016 14:01

Lee Wild from interactive investor

When Thin Lizzy sang The boys are back in town, I'm almost certain they weren't singing about key decision makers in the Square Mile and on Wall Street. But it's the return of big hitters that typically marks an end of the summer malaise and a significant uptick in trading volumes. It's already happening, but things are complicated this year and opinion is divided.

Brexit ended the debate over our membership of the EU, and the removal of such massive uncertainty caused one of the most spectacular stockmarket rallies of modern times. But with Article 50 kicked into 2017, it's US interest rates that dominate the headlines.

Now, I understand perfectly well what the implications of higher borrowing costs might be, both for Americans and the rest of us. Getting it wrong will have consequences. But Fed policy has turned into a low budget soap opera, with air time given over to its "grey" protagonists far outweighing their significance.

Record-low rates caused a stampede into high-yielding equities, acting as bond proxiesFurther comments from Boston Fed president Eric Rosengren dumped markets lower last Friday and Monday.

It's logical then that the outcome of next Thursday's rate-setting meeting will shift markets, currently in a holding pattern, but with risk appearing to the downside.

Whatever happens, with no chance of a move in Presidential election month, speculation over rates should die down. Maybe then the prospect of President Trump in the White House will sharpen traders' minds, or perhaps the possibility that central banks might be about to slam the brakes on further monetary stimulus.

Then there's valuation. Record-low interest rates have caused a stampede into high-yielding equities which act like bond proxies. But they're now incredibly expensive - over a third of the FTSE 100 currently trades on a forward price/earnings (PE) ratio of 20 or more.

Top analysts are split over the implications. Dennis Jose at Barclays acknowledges potential banana skins like maturing profits cycle in the US, a sharp slowdown in China and the economic impact of Brexit, but he argues that "sentiment, positioning and valuations do not embody the exuberance that characterizes the peak of a bull market".

He also spots a convincing correlation between excess real money growth (M1 money supply) and the change in PE:

"Our work suggests that the pace of excess money growth far exceeds the lows seen prior to major bear markets, and remains supportive of further multiple expansion. If we are right, higher multiples should by extension translate to higher equity prices provided that the earnings do not collapse."

Expect the FTSE 100 to end 2016 at 7,000, according to Barclays.

But the team at UBS is not convinced. They argue that to get noticeable upside from here there must be either 30-40% earnings per share growth on average PE multiples, or further multiple expansion from 16 times currently. Recalculating internal forecasts based on an upgraded PE ratio of 13.9 (from 12 times) "struggles" to get upside for the FTSE 100. On predicted profit growth of 8% both this year and next, fair value for the index is 6,500.

UBS also believes the UK looks "somewhat overbought" on short term technical indicators, which ties in with my own calculations and those of chartist and Interactive Investor contributor Alistair Strang.

Alistair's software tells him the FTSE 100 will eventually bottom at 6,532. Our chart above points to the next line of support at around 6,500, being the 62% Fibonacci retracement of the decline from May 2015 record high to the post-referendum low.

In summary, the market has been too quiet this summer. Volatility represented by the VIX index has traded at around 11, its lowest for a year. It was 26 at the end of June and as high as 90 during the financial crisis. But now it's creeping up, topping 20 this week, which implies selling pressure.

A shake-out of some kind can be expected. As John Kosar, chief market strategist at Asbury Research said to MarketWatch recently, "you need to have a little scare to get it to recycle". He's right, but the hot money needs a home and, just now, there's nothing that compares to the income generating power of equities. It's why investors will continue to buy the dips.

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.