Equities – A reason to be cheerful?

23rd December 2011

The forecast comes from Richard Buxton, head of UK equities at fund management group Schroders who reckons that "investor sentiment has been so subdued" by "the self-fulfilling run on confidence in European banks and sovereign states" that any sense of resolution will "provoke an extreme positive reaction from equity markets".

In Buxton's look ahead into 2012, he hopes the "risk-on, risk-off" scenario seen in 2011 – markets became increasingly correlated between asset classes while only macro-economic factors seemed to hold any sway – to give way to some lessening of macro uncertainties.  And that, he says, "will provide the initial catalyst" for "greater dispersion of returns within the market" – in other words a return to the world where equities presented a higher risk but also a suitably higher return than bonds for investors who get their stock picks right.

What is the optimism based on?

Next year, much depends on a rerating resulting from a positive resolution to the euro crisis. If the problems are solved, then equities will react accordingly. But the fund firm warns that the UK equity market cannot rely on growth in the economy whatever happens to the euro  – flatlining is the best hope given the squeeze on real incomes and public spending cuts. Nor can anyone count on a sudden influx of new money from eager investors. All that counts in the near future is better news from the eurozone.

Looking longer term into the crystal ball.

After a dozen years of go-nowhere equity markets, investors are naturally disillusioned and fatigued. But a decade or so ago, the equity market sold on 24 times annual earnings, a figure that could only be sustained with non-stop economic growth at levels rarely if ever seen in the UK. Now it trades on nine times earnings – a move seemingly into distinctly oversold territory.

Buxton says the economy is not in calm waters – the banks alone will take years to recover.  But "starting values are crucially the key to future returns" so "if history is any guide", the next 10 years should provide double-digit returns "despite the economic headwinds."

What can go wrong?

Plenty. This is a binary market – it's either up or down depending on macro-economic results with most investors holding fire until that course is clearer.

Buxton realises that valuations alone won't produce the goods – he expects more earnings downgrades over the next few months. The financial crisis – or sense of crisis – will not be going away soon while the banks will continue to rein in lending.

But quoted corporate Britain – and especially the big companies that form the basis on most dividend-oriented funds – enjoy good margins, healthy balance sheets, attractive returns on capital and – see this forward looking note on income shares – dividends are rising again. 

 

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Lessons of history – is today an attractive time to invest in equities?

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