Volatility remains with further bear market rallies expected

Jane Coffey, Head of Equities at Royal London Asset Management and fund manager of the Royal London UK Equity Trust comments on the outlook for UK equities: We have had less than ten trading days and already 2009 is proving to be a very volatile year. The aftermath of the Christmas rally saw the market rise 6% before losing all the gains it had made in December. Market historians maintain that January's market direction more often than not predicts the direction for the year. This year I think even the first few days of trading illustrate exactly how I see the market continuing over 2009. In short, I believe volatility is here to stay.

So how do you insulate portfolios from such violent movements? Strong balance sheets will, I believe, continue to be a key differentiator between the winners and losers. Companies that do not need to refinance their debt or issue equity will have a huge advantage over their competitors that do. Even if their earnings fall sharply during the downturn, they will survive to see in the recovery and shareholders will enjoy the benefits as profit margins rebuild. Despite relatively strong performance through 2008, I still think many of the mega cap stocks in the UK offer an attractive risk/reward profile given their low debt, strong cash flows and high overseas earnings, supporting their ability to pay good dividend yields. Therefore, my core investments will remain in stocks such as GlaxoSmithKline and AstraZeneca as well as Vodafone. In contrast, the banks look likely to need more capital, as do many of the real estate and leisure stocks. This means that, not only will there be no dividends likely from these companies in the short term but existing shareholders will be diluted out of any recovery.

Given the sharp falls we have already seen during this cycle, it is likely that we will enjoy several more bear market rallies as investors feel they have over-discounted the bad news. This usually leads to a change in sector leadership and I would expect to see a recovery in many of the heavily sold down sectors such as retail, house builders, leisure and resources. I would however maintain a cautious approach to buying the recovery as it remains more important than ever to focus on balance sheets. History has shown that insolvencies often peak as an economic recovery begins. Just getting by during the bad times is not enough; investors will need to be happy that a company has not run down its productive capacity or retrenched into an intrinsically smaller business. Some of the attractive companies in this respect would include Persimmon, Home Retail, and UBM.

Picking the timing of market rallies is notoriously difficult, although it is likely that the inventory cycle will turn towards the second quarter of this year as the involuntary inventory build will reverse. We have already seen double digit falls in industrial production across Europe, and companies have been running down their inventories to preserve cash, meaning we are getting closer to the time they will be re-ordering components and, in particular, commodities. A strengthening in industrial metal prices would be a good indication this was happening and would, I believe, lead to a significant jump in the oil and mining stocks which account for over 25% of the FTSE All-Share. As always, investing in companies with a strong balance sheet has paid dividends in recent times. As such, companies like BHP Billiton and BP have been the better performers during the downturn but will also be best positioned to make cheap acquisitions ahead of the upturn.