How to assess whether UK stocks can raise a gallop to the end of the year
Any advisers and clients who followed the old market maxim “Sell In May” won’t feel too sore, as the FTSE 100 made awfully hard work of scratching out a 2% capital gain during the summer months.
But a gain is a gain and the index’s ability to make any progress at all in the face of the ongoing Brexit negotiations, heated rhetoric between North Korea and the USA and a spotty summer reporting period from UK stocks may further embolden those advisers and clients who are bullish of UK stocks.
They may be adhering to another adage, namely that “markets climb a wall of worry,” but they may also be looking forward to seeing the results of the second half of the “Sell in May” message, which is “Come back again on St. Leger day.”
Saturday 16 September was St. Leger day this year, as Doncaster’s Town Moor track hosts the final ‘Classic’ horse race of the Flat season, so advisers and clients may now feel this is the time to assess their strategy as we prepare for the run-in to the year end.
Advisers and clients will doubtless have their eye on three issues in particular:
- Brexit: It is hard to say anything cogent or add value on this topic when the leading players themselves appear to have no idea of how the negotiations are going to pan out. The only thing that can be said with any degree of confidence at the moment is that sterling seems to rally when it thinks a ‘soft’ Brexit with a post-2019 transitional period is coming, and weaken when it thinks a ‘hard’ Brexit is coming. But even these concepts are nebulous and relying on the skittish foreign exchange markets for a steer on other asset classes is probably a mug’s game.
- Monetary policy: Just like the Bank of Japan and the US Federal Reserve, the Bank of England remains perplexed as to why very low unemployment is not leading to higher wage growth. And this confusion over why the so-called Phillips Curve is apparently no longer working means Governor Mark Carney and the Monetary Policy Committee (MPC) still seem in no rush to increase interest rates or withdraw any of its £445 billion Quantitative Easing scheme. The vote at Thursday’s MPC meeting was 7-2 to do nothing (for the second meeting in a row) and markets do not expect a rate rise until mid-2018 at the earliest. Some economists think the Old Lady of Threadneedle Street may wait until after Brexit in 2019.
- Earnings: Further studious inactivity from the Bank of England may keep sterling weak and that could at least help UK corporate earnings. Over two-thirds of the revenues and profits generated by the members of the FTSE 100 come from overseas, so that income becomes worth more when translated into sterling if the pound remains weak.
The good news is that analysts expect healthy increases in earnings from the FTSE 100 in 2017 and 2018. The bad news it the quality of the increase looks poor and the rate at which analysts have been upgrading their numbers is tailing off badly – something that looks to coincide with the index’s struggles to make any telling fresh ground over the summer.
Raising a gallop
The saying “Sell in May, go away and come back on St. Leger day” has its devotees for good reason, because like any such saying it has enough of a grain of truth in it to keep it relevant.
This table shows the average gain in the FTSE All-Share since 1965 over three distinct time periods: 1 January to 30 April, 1 May to 10 September (the St. Leger is unusually late this year, taking place on the third Saturday of the month, rather than the second) and then 11 September to 31 December.
As we can see, the index, on average, does best before May, nothing during the summer and then rallies again as we head toward Christmas.
There is a grain of truth behind the old “Sell in May” saying
Source: Thomson Reuters Datastream
However, that exact pattern of a gain, then a drop, then a gain has only been seen in 14 of the last 52 years, or just one third of the time.
And nor did that trend develop this year. The FTSE All-Share advanced by 2% between May and early September, to supplement the 2.3% capital gain offered in the first four months of 2017.
This is the nineteenth time since 1965 that the FTSE All-Share has advanced in each of the first two periods of the year. Bullish advisers and clients will be pleased to hear that on 14 of those occasions, the index also rose in the final third, with an average capital gain of 5.3%.
The FTSE All-Share has historically ended the year strongly after gains in the first two-thirds of a year
Source: Thomson Reuters Datastream
The exceptions, for the record, were 1977, 1980, 1989, 1991 and 2014. In all but the last-named the index made gains for the year as a whole anyway.
History therefore seems to be on the side of the bulls, at least in the short term.
However, we all know that the past is no guarantee for the future. We also know that profits and cashflow – and the price paid to access them (or valuation) – ultimately determine long-term returns from stocks (or indeed most long-term investments).
AJ Bell has therefore revisited its earnings model for the FTSE 100, which aggregates the analysts’ consensus forecasts for each of its members – and since this index represents more than 85% of the UK’s total market capitalisation, it is a pretty fair proxy for the UK overall.
The good news is that analysts expect a healthy increase in aggregate pre-tax profits, on a stated basis, from £96 billion to £191 billion for 2017.
This year is almost over, though, and the market’s attentions are already focused on 2018 and beyond, where the consensus view calls for a further 11% rise in pre-tax earnings to £213 billion.
That figure exceeds the £205 billion peak reached in 2011 and therefore helps to justify the FTSE 100’s (and the FTSE All-Share’s) proximity to their all-time highs.
Aggregate FTSE 100 profits are forecast to reach new all-time highs in 2018
Source: Company accounts, Digital Look, analysts’ consensus forecasts
Mix and match
However it may not all quite be plain sailing.
Even as the pound inched lower over the summer, analysts stopped nudging their forecasts higher – and actually started cutting them, at least for 2017.
After increases to aggregate FTSE 100 pre-tax income forecasts for 2017 in Q2, Q3 and Q4 of last year and Q1 of this, estimates flattened out in Q2 and then slid by 3% in Q3.
Estimates for combined profits in 2018 have been flat at around £215 billion for the last two quarters.
Consensus earnings estimates for the FTSE 100 have stalled again
Source: Company accounts, Digital Look, analysts’ consensus estimates
Profit warnings from media giant WPP and credit provider Provident Financial will not have helped but they represent less than 1.5% of the FTSE 100’s aggregate earnings and there appear to be three bigger factors at work:
- Oil is struggling to break-out beyond $55 a barrel
- Mining analysts don’t seem to trust the summer strength in copper, aluminium, iron ore and zinc, as they are forecasting fresh declines in miners’ earnings for 2018
- Profit estimates for the banks are stalling again and look stuck at around £30 billion for 2017 and £36 billion in 2018 (a figure which finally takes them back to the peak levels of 2007).
These are far more important than the woes of WPP or Provident Financial. For 2017, financials, oils and miners are forecast to generate 49% of aggregate FTSE 100 pre-tax profits and 70% of aggregate estimated profit growth.
To this column’s mind, this is a pretty low-quality mix. Banks are growing their earnings by cutting costs and (hopefully) cutting down on compensation payments to customers and litigation costs and regulatory fines. That won’t last for ever and top-line growth is likely to be modest, given competition, regulation and the prevailing levels of debt, with only riskier lending and investment banking offering growth avenues (but ones that come with inherent dangers).
Banks, miners and oils dominate FSTE earnings (and profits growth) forecasts
Source: Company accounts, Digital Look, consensus analysts’ estimates
The quantity of earnings may be good but the quality appears variable.
Advisers and clients must bear this in mind when they assess their portfolios and the equity portion they allocate toward the UK, especially if they prefer to use passive instruments, such as tracker funds or Exchange-Traded Funds (ETFs). Such tools automatically expose them to these mix issues.
Advisers and clients will also need to divine the views of their selected fund managers on those three key sectors of banks, oils and miners when it comes to assessing which collectives to use for their exposure to the UK.
Best performing UK equity flex-cap funds over the last five years
Source: Morningstar, for UK Equity Flex-Cap category.
(Where more than one class of fund features only the best performer is listed.)
Best performing UK equity investment trusts over the last five years
Source: Morningstar, The Association of Investment Companies, for the UK All Companies category
(* Share price. ** Includes performance fee)
Best performing UK mid-cap Exchange-Traded Funds over the last five years
Source: Morningstar, for UK Mid-Cap Equity category.(Where more than one class of fund features only the best performer is listed).
Russ Mould, AJ Bell Investment Director