Is the stock market rally sustainable?

5th February 2013

Is 2013 the year of the bull, or is the stock market surge simply a fallacy, with investors falsely believing the bad news is behind us asks financial journalist Harriet Meyer.

The year has proved positive for investors across the globe, continuing the rally in stock markets from the second half of last year, and sparking a great rotation out of bonds into equities.

The FTSE 100 surpassed the 6,300 mark for the first time since May 2008, posting a return of 7 per cent in January – its best since 1989. And Citigroup has revised its FTSE 100 forecast for 2013 up to 7,000.

But is this a superficial sweet spot?

After all, the market’s momentum is being driven by sentiment. This is despite the troubled backdrop, with the UK economy continuing to stutter amid the spectre of a triple dip recession. Yet this underlying economic reality hasn’t been reflected in share prices – with equities soaring.

So why the confidence? Relief that US lawmakers agreed a last-minute package of measures to avoid the ‘fiscal cliff’, alongside renewed hopes that the debt crisis in the EU was abating saw some of the uncertainties that stalked markets wiped out. Investors’ worst fears have so far failed to materialise.

This results in a bullish mood, but the rally risks being unsustainable – particularly in the short-term, when there could be a sudden correction alongside a further tide of poor data.

 So are we in a period of over-optimism?

 Gavin Haynes, investment director at Whitechurch Securities, says: “Particularly important in determining how far the rally can extend will be the performance of the two biggest global economies; US and China, and whether the improved economic data witnessed since last summer can continue.

“At the same time Europe will remain at the forefront of issues which could determine whether markets make further gains in the near-term.”

Thomas Becket, chief investment officer at Psigma, adds: “Vital also to the direction of equity markets will be the earnings growth that companies can generate in the months and years ahead, and key to corporate profitability will be economic growth and interest rates.

“However, the ability of companies to cut costs and widen profit margins has now passed and many companies are already operating as tight a ship as possible. Indeed, profit margins remain at historically elevated levels.”

He says that equities will have to climb the “wall of worry”. “The structural and cyclical risks will continue to rear their respective and collective ugly heads and ensure volatility is here to stay.”

And let’s not forget the excessive money printing, with central banks committing to do whatever it takes to eliminate tail risk and restore economies to growth. The consequences of this have yet to be felt.

But there’s no denying that at present other assets hold little to no appeal in the low-interest climate, and a return of risk appetite should buoy the economy, aiding growth and bold decision-making.

So how far could markets go?

Darius McDermott, managing director of Chelsea Financial Services, and a Mindful Money blogger, says: "This rally is being driven mainly by a change in sentiment – but it’s gone a long way very quickly so may be over done in the short term. However, investors could see a trading range between the high 5000s and mid 6000s for a while.”

Yet this is far from previous highs, points out Ben Yearsley, head of investment research at Charles Stanley. He says: “Today's market is very different to the one that hit almost 7000 in 1999. Markets change and move on, companies develop and grow and despite the recent rise the market multiple is still a lot lower than at the turn of the millennium.” 

“And we have had such a strong run in the markets that it is probably due a pause for a while in order that company news flow and earnings can try to catch up.”

Given the fickleness and short-term crowd mentality that frequently drives markets, it wouldn’t take much negative corporate and economic news-flow to see an increase in risk aversion and a short-term correction.

So while there remain buying opportunities for the long-term investor, beware the short-term complacency that has seen equity markets soar to produce one of the best starts to the year in decades, stresses Becket.

He adds: “Coming after a strong end to 2012, we believe that markets have moved too far, too quickly and it is prudent to bank some profits and re-evaluate the short term downside and upside risks.”

There is potential for disappointment so a degree of skepticism doesn't hurt in these circumstances.




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