F&C's Scott on the market prospects for 2007

Currently many fund managers are arguing that shares still look cheap, despite the sharp price rises last year.

In the note below Ted Scott, Manager of F&C Growth & Income Fund, argues that the market has in fact re-rated upwards and shares look fully valued on a PE of 15 times earnings.

He points out that markets tend to overshoot, so expects further rises of 10%. However, risks are rising as the financial system is fragile.

Market Prospects for 2007

Re-rating of the market

It became apparent in the final quarter of 2006 that the UK market has enjoyed a re-rating to a higher PE multiple. Some strategists believe that the market has not yet been re-rated as earnings growth almost kept pace with returns from shares last year (around 15%) but this overlooks the fact that the median PE expanded significantly and so the vast majority of quoted companies have indeed been accorded a higher valuation. Of greater significance is the fact the resources sector still provided a significant proportion of the earnings growth (mainly the miners) and that is a deep cyclical sector. If earnings growth is 'normalised' then I reckon it is fair to assume the market has been re-rated by 10% - approximately 13.75x to 15x.

Why has the market re-rated?

It is because of excess liquidity and what Citigroup calls 'de-equitisation'. Broad money supply growth has accelerated sharply in the last 2 years at a time when interest rates, bond yields and inflation remain relatively low. As yet the rise in the money supply has not led to inflationary pressures and the issuance of government and corporate bonds has been met with insatiable demand that has absorbed quite a lot of new money. This is partly due to the requirements of pension funds to match liabilities with fixed income assets but also because of the quest for yield in a low income producing world.

The above is a global phenomena but it is has also led to asset bubbles in various classes as the liquidity has sought a home, most notably property (both commercial and residential). Whether the borrowers are corporate or private it has been easy to borrow money and with interest rates so low the immediate risk of default also appears limited. On the corporate side private equity houses have, in particular, been rapacious borrowers and have had no problem in raising billions of dollars or pounds that have partially fuelled the explosive growth in mergers & acquisitions during 2006. As a result, credit spreads have narrowed to record levels helped by the rapid development of the credit derivative market that has spread the risk between the lenders.

On the private investor side it is much easier to borrow large multiples of salary for mortgages and the level of debt means that savings ratios are historically very low.

For the stock market, the credit based M& A boom has been largely cash and debt based as it is relatively inexpensive compared to the cost of equity. While interest rates and bond yields remain low it is difficult to see why this trend should not continue. The theme of de-equitisation has also aided the re-rating of the market. Company balance sheets are generally strong and rather than embark on acquisitions or capex the preferred choice has been a return to shareholders via higher dividends and share buy backs. Cynically, this could be said to be because it is beneficial to the share price (e.g. Enterprise Inns) but it is notable that the mega cap stocks have been reluctant to de-equitise despite their inefficient balance sheets and this is a major contributory factor to their poor performance.

Risks to the status quo

There are no obvious risks, which is why the consensus view is even more bullish at the beginning of 2007 than a year earlier despite the strong rise in the market. However, there is no doubt in my view that there is more risk in the financial system than there was a 12 months ago: credit spreads are very low, volatility is near an all time low, personal debt is high, private equity borrowing is high etc.

There are various scenarios where the benign environment we enjoyed last year could be derailed. Perhaps the most unexpected would be a rise in US interest rates. This is what caused the bear market in 1994 as it came out of the blue. At present, the market is signalling the next move in US rates will be down but the Fed speak is still quite hawkish with respect to inflation. Fed Chairman Bernard Bernanke is a known inflation hawk and if inflation were to worsen due to wage pressure or further commodity price rises, a rate increase is a possibility.

On the contrary, a decline in rates would signal a capitulation by the Fed to the markets and be an acknowledgement the economy is weaker that it has hitherto recognised. If it became apparent the US growth was slowing faster than the market is assuming (which is probably around 2.5-3% for a soft landing) it would imply weakening profits and earnings growth and the market would find it hard to make headway after such a strong run.

If inflation were to pick up and bond yields to rise then credit spreads and volatility would also increase. This would have an adverse effect on M& A activity that has been a major prop for the market, especially in smaller and mid cap stocks. A commensurate de-rating in this area of the market could ensue.

On a global scale the main risk is a disorderly decline of the dollar. The US deficit is still at record levels despite the modest decline but overseas capital flows could significantly deteriorate if it was seen that the US economy was weakening and interest rates were to fall. So far, the slow down in the US has been offset by strength in other economies in the EC and Far East but a sharper than expected slowdown in the US would have a big impact in the Rest of the World as well. Of course, there remains the ongoing risk of an external shock, mainly a major terrorist atrocity.

Possible Outcome

Following the rise in the UK market in the last quarter it is already trading at around 15x (i.e. full valuation). However, bull markets typically overshoot by up to 10% so I would expect equities to continue to advance early in 2007

However, a correction or bear market is looming not only because of the fragile nature of a precariously balanced financial system, but also because the market has now achieved a re-rating that reflects the cheap and abundant liquidity around. If any of the above risks materialise then I would expect to see the market lower at the year end than the start of the year, not least because the earnings growth that has supported the market's rise for the past 4 years would be absent.

Ted Scott