EquitiesOct 2 2013

A bull market is coming this way

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Typically there are periods – structural bull markets – where real returns are strong for several years and these are followed by periods – structural bear markets – where real returns tend to be flat at best and highly volatile to boot.

In the UK for example, the years 1969 to 1981 witnessed a structural bear market during which real equity returns averaged -1.8 per cent a year over 13 years. This was followed by a fantastic structural bull market with real returns averaging +13.6 per cent a year over 18 years (1982 to 1999).

This gave way, unsurprisingly; to another structural bear market, which has been running since 2000 and has now completed its 13th year (real returns during 2000 to 2012 have averaged -0.2 per cent a year).

So, with the FTSE 100 having risen close to 100 per cent over the four and a half years since the March 2009 low, and approaching the 1999 peak of 6930, the question of whether we are in a cyclical or structural bull market is important. If we have just experienced a cyclical bull market within an ongoing structural bear phase then, if history is any guide, the good times will likely be coming to an end fairly soon. However, is it possible that we are emerging from a 13-year bear market into a new structural bull market?

Starting valuation is the primary driver of medium-term returns from investments in UK equities (as opposed to GDP growth or corporate profits growth, for example). The primary reason the UK equity market has delivered flat real returns over the last 13 years is because by the end of 1999 the market was on a P/E multiple of 26x and by the end of 2012 the multiple had fallen to 11.5x. The fact that GDP and corporate profits grew strongly during the period was completely overwhelmed by the decline in the P/E rating.

The good news is, given where valuations are today, there is a high probability of strong returns from UK equities over the medium term.

Using data going back to 1970, double-digit annual returns over the coming decade are probable from today’s starting valuation, which should look extremely attractive relative to likely returns from most other competing asset classes.

What will be the key drivers of those multi-year double-digit returns should they come to pass? In the short term we continue to expect recovering economic growth globally to drive further gains in corporate profits, which in turn should support further advances in the equity market. In the medium term I am intrigued by the potential for the valuation on the stock market to rise again, if UK equities show signs of becoming a more popular asset class with investors than they have been generally over the last decade or so.

Assets typically need a compelling ‘story’ to become popular and as we look forward there are several plausible stories that might be advanced in favour of increasing equity weightings again. In no particular order they include: relative value attractions compared to other assets, structural decline in institutional equity ownership that has gone too far, a reasonable hedge against higher inflation than experienced in recent history, some great new technological advances yet to be commercialised.

Regardless of which of these, or alternative rationales, end up reinvigorating equity popularity we are optimistic that enthusiasm can return and there are some early indications in the aggregate flow data to suggest that process is starting to occur (inflows into equity funds globally have picked up materially in the year to date for example). As such, we are potentially coming to the end of the structural bear phase and consequently are in the very early stages of a new structural bull market.

If the medium-term outlook is an optimistic one, what of the near-term outlook? While there are always issues that can give rise to temporary bouts of volatility (such as ongoing eurozone unrest, geopolitical tensions in the Middle East, slowing growth in China and debt ceiling debates in the US), my view remains constructive, driven by a re-acceleration of economic growth momentum globally, attractive valuations and earnings forecasts that look appropriately set following a period where growth expectations have been recalibrated lower.

The most significant recent development though centres on government bond yields that, having risen sharply recently, look to be heading higher into the medium term more or less across the globe. If this proves the case then it is highly likely that sector leadership within the UK equity market will change.

Over recent years UK equity market performance has been dominated by stocks that can best be summarised as ‘bond-like’. That is, those companies that have exhibited steady, consistent earnings growth with low variability. The chart below highlights the extent of the recent outperformance of such defensive growth shares.

In an environment of rising bond yields and accelerating economic growth I suspect the relative attractiveness of such stocks will fade and new leadership will emerge. In particular, consider the following two key areas for future leadership in the UK market:

• Financials. Banks, life insurers and financial services companies are prime beneficiaries of a rising bond yield environment. Banks in particular still suffer from the legacy issues of the global financial crisis, with many investors remaining cautious on the sector given ongoing regulatory threats and uncertainty of balance sheet cleanliness and strength. Therein lies the recovery opportunity still to be fulfilled as the world continues to slowly recover and normalise.

• Cyclical sectors. As growth reaccelerates cyclical sectors of the market typically perform well. We are particularly keen on opportunities in industries such as travel and leisure, general retail, support services and house building and have numerous holdings in these areas where the outlook remains extremely positive.

Following a long, difficult and frustrating period in the UK equity market stretching back to the turn of the century, I am optimistic that the combination of attractive value, a slowly normalising global economy and current investor apathy towards UK equities points to a medium-term outlook that is considerably brighter than recent history. I also expect internal market leadership to change and an ability to be flexible and adapt to those changes will be important in delivering good returns to clients in the future.

Undoubtedly there will be bumps along the road and there are plenty of risks that could derail best-laid plans. There always are of course, which is why you achieve 5 per cent to 6 per cent a year long-term real returns from equities. We need to be mindful of how, typically, those returns accrue over time and, following an extended barren period, there is the potential of significantly better returns ahead.

Simon Murphy is manager of UK Equity Fund of Old Mutual

Key points

* Questions are being asked about whether we are about to move from a cyclical to a structural bull market

* Given where valuations are today, there is a high probability of strong returns from UK equities over the medium term.

* The most significant recent development centres on government bond yields which, having risen sharply recently