Equities on the mend

Equities on the mend

After a few false starts, the FTSE100 finally stumbled across the 7,000 line on 20 March, breaking through a psychological barrier which seems to have held investors back from rallying behind the UK’s biggest companies for some time.

But away from the popping corks and clinking glasses, a number of naysayers have questioned the significance of hitting the landmark.

While it is true that an arbitrary milestone should not have any bearing on underlying fundamentals, there remains a strong case for the FTSE 100 continuing its climb toward the next millennial milestone. Equities will remain choppy, and volatility may indeed increase, but we see plenty of leg room for investors to make further gains over the next few years.

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Recent market gains owe much to low interest rates. In particular, loose monetary policy and quantitative easing, sustained by Federal Reserve caution, suggest that a rate hike is still some time off. Low rates across different fixed-interest assets and benign yield curves provide firm foundations for further equity market gains.

While the FTSE 100 reflects the prospects of many truly global businesses, positive economic news from the UK also has an impact on the outlook. UK GDP figures have been pointing in the right direction, and the ONS has revised up Q4 2014 growth, adding cause for optimism. Businesses exposed to UK consumers are also expected to benefit from the temporary low inflation brought about by lower oil prices which is effectively putting money back into people’s pockets.

Some still question the equity market’s sustainability, and their caution might not be misplaced, given that, following initial strength last week, the FTSE 100 has since fallen below 6,800.

However, one key measure of market value, the prices/earnings ratio, indicates that equities are not overvalued. We can see a gilts price/earnings ratio of 65.9 against an equity price/earnings ratio of 15.5 for the FTSE 100. This suggests that the FTSE 100 continues to offer good relative value, especially considering that equity P/E ratios have declined since 1999/2000, while gilt P/E ratios have tripled.

In addition if we look at income yields, FTSE 100 stocks and UK government gilts have reversed their historic relationship since 1999/2000.

As the table shows, quantitative easing and low inflation have depressed gilt yields from 5.48 per cent in December 1999 to around 1.52 per cent now, while during the same time period the dividend yield from FTSE 100 stocks has risen from 2.35 per cent in to above 3.5 per cent. These dividend payments look sustainable across the FTSE 100 in aggregate which should underpin equity values.

10-year gilt yieldFTSE 100 dividend yield
Dec 30 19995.48%2.35%
Mar 20 20151.52%3.5%

Yields may provide clues about value, but they do not tell the whole story, and it is important not to overlook inflation when thinking about value. Dividend payments from equities across the FTSE 100 typically rise in line with inflation and GDP growth over the medium term, providing implicit protection against rising prices.