The last trading day of 2017 saw the FTSE 100 and its junior sister, the FTSE 250, hit new highs. But what is this telling us about the real world?
The famous economist, Paul Samuelson once said that the stock market has predicted nine out of the last five recessions. In short, what happens with the economy and what happens with the stock market is only vaguely connected.
Well, that might be true in the short term, but surely over the long run there must be a link.
The FTSE 100 finished 2017 at 7,687.77, up roughly seven per cent on the start of year price. Incidentally, there is a theory known as the ‘Santa Rally’ which suggests that for accounting reasons, many funds buy stocks at the end of the year, meaning that we often see surges in the stock market at the year’s end, so the performance of the FTSE 100 in December seems to support the theory.
But before we wax lyrical about the FTSE 100, just bear in mind that compared to other indices, the index was something of a laggard.
The S&P 500, for example, rose by around 20 per cent. The technology dominated NASDAQ was up 30 per cent. The FTSE 100 wasn’t even the best performing index in the UK, the FTSE 250, which tracks the 250 biggest companies after the top 100, was up 13 per cent, or so.
So, can it last?
Alas, there is no clear consensus. The pessimists, called the bears, look at the so called trailing PE ratio which compares valuations with earnings and point out that right now the ratio is at 30, double the historic value. People like Neil Woodford, the UK’s most celebrated fund manager, say that stock prices were distorted by record low interest rates, and quantitative easing. They also cite bitcoin as an example of irrational optimism - which they say is part of a wider phenomenon.
The optimists, the bulls, say that if you compare the valuation of the FTSE 100 with earnings over the past ten years, a ratio known as the CAPE, you get a ratio of 16, pretty much average, and well below the 20 year average, which is around 20.
A factor at play is the commodity cycle. Commodity prices have been low in recent years, but there is a consensus that the commodity cycle is set to turn upwards - indeed commodity prices did rise at the end of 2017. Higher commodity prices will be especially good for the FTSE 100, which counts a lot of miners and oil companies among its larger members.
Another factor is the pound. Because the FTSE 100 is dominated by companies that do most of their trading abroad, a fall in sterling is seen as good for the index. But it is generally thought that 2018 will see the pound rise, which in theory should be bad for the index. But when you look at the performance of other stock indexes which boomed without the boost of a falling local currency, this argument makes less sense.
Interest rates are likely to rise in the US and UK in 2018, in the euro area, quantitative easing is set to come to an end. Will this lead to falling stock prices? Maybe, but bear in mind that rates are expected to rise because the global economy is expected to grow at a brisk pace in 2018. Indicators suggest that the US and euro area are going to see their best performance this decade. And actually, and despite the protestations of Paul Samuelson, when the economy is strong so should the stock markets flourish.
