Just as the FTSE 100 was looking poised to break the 8,000 barrier, Italian political turmoil and US-China trade tensions are putting stocks on the backfoot. This recent pullback provides a good opportunity to take the temperature of the market.

Given the index had added more than 1,000 points since late March, many investors had even begun to ask how long before it could break the 10,000 barrier.

And there are still reasons to think the FTSE could again turn higher.

Companies and large investors like private equity are flush with cash and there is a view that the recent spurt of takeovers is only just the start of a wave of M&A. That could be a strong driver for the market, as well as the fact that equity valuations aren’t overly expensive in large parts of the UK market. Equity (or equities) is another term to mean stocks and shares.

Stocks in the FTSE 350 with large exposure to the UK economy are certainly trading on undemanding valuations, so are many stocks with overseas interests.

LACK OF EUPHORIA IS GOOD

It is impossible to accurately predict where the market will head next, yet you could argue that we haven’t seen the mass euphoria stage which normally accompanies the end of a bull market.

Think how bitcoin was mentioned on every news channel and was the talking point in pubs, taxis and at work – that’s the kind of euphoria which suggests bubble territory.

Yet the state of the stock market arguably isn’t a hot topic for office workers chat around the water cooler on their lunch break. And have you been offered stock tips by taxi drivers and hotel bellboys? Probably not, which suggests the euphoria stage is still to come.

Hitting 8,000, 9,000 or even 10,000 would be great news for the UK’s army of investors who have turned to the markets to obtain a greater return than is currently available on cash.

It would also be a fantastic achievement in the face of obvious worries about Brexit negotiations, an indecisive Bank of England and modest UK economic growth.

WHAT YOU WILL GET FROM THIS ARTICLE

This article will take a closer look at the current state of the market and provide a checklist of important points which can help you ascertain whether it’s going to be boom-time for a lot longer, or whether there are a few cracks appearing which could lead to more serious concerns in due course.

We believe the market can regain momentum, but we also recognise there are some warning signs bubbling away. This suggests you should keep some money in cash in case there is another market correction in the near-term, so you have some firepower to pick up stocks amid any price weakness.

WHY HAS THE FTSE ACHIEVED NEW RECORD HIGHS THIS YEAR?

Investment experts say a weaker pound and a surging oil price have played a big part in the recent stock market rally, among other factors.

Around two-thirds of the FTSE 100 index’s earnings come from overseas, so the lower the pound goes, the more those foreign earnings are worth when they are translated into sterling.

‘This explains why the FTSE 100 did so well in 2016 and early 2017, as the pound fell in the aftermath of the EU referendum vote,’ says Russ Mould, AJ Bell investment director.

The Bank of England’s failure to tighten monetary policy earlier in May by keeping interest rates wedged at 0.5% has clearly given the FTSE 100 another push. Sterling has also been weak recently amid disappointing UK economic data.

Brent Crude’s rough 75% rally since June last year is another big plus for the UK’s blue-chip index.

Sector heavyweights BP (BP.) and Royal Dutch Shell (RDSB) are the second and third largest ranked companies in the FTSE 100, by market value, and between them represent 25% of total FTSE 100 sales, 14% of profits and 20% of dividends for 2018, according to consensus analyst forecasts.

It is easy to forget that the FTSE 100 had a very poor start to the year, leaving the UK market at its ‘largest price to book discount to the S&P 500 in at least 18 years,’ according to Charles Montanaro, manager of the Montanaro UK Income Fund (IE00BYSRYZ31).

This presumably helps explain the rampant run of mergers and acquisitions targeting UK businesses recently. FTSE 100 members Shire (SHP), Sky (SKY) and Smurfit Kappa (SKG)
have all been on the receiving end of takeover interest this year.

Patrick Thomas, investment manager, Canaccord Genuity Wealth Management, believes the ‘mood music’ is changing. ‘What we saw in that first quarter was we saw more money going into equities than we’d ever seen, and with the tax cuts in the US and the share buybacks, there was an added ferocity to that inflow.

‘But for all of that, the markets ended the quarter on a weak note, and as we’ve seen, this was despite the fact that US profits rose by some 15% year-on-year, almost the strongest sequential numbers ever.’

Stock markets in many parts of the world have enjoyed a strong recovery so far in the second quarter of the year. However, on a broad basis, the FTSE 100 has lagged global peers in terms of performance, says Martin Newson, chief executive officer at Optimus Capital.

‘As we get closer to the UK leaving the European Union, we think there is scope for the FTSE 100 to outperform UK smaller companies, which are usually more sensitive to the domestic environment.’

Not everyone is bullish on the market outlook. For example, Peter Garnry, head of equity strategy at Saxo Bank, believes the recent market drivers will lose their thrust over the coming months. He is negative on UK equities on a short-term view.

Inflation remains a key threat to further stock market gains. It could lead to higher interest rates, reducing consumer spending power while upping corporate operating costs.

‘The jump in the oil price has started to hit petrol pumps, pushing up costs for UK consumers and businesses alike, which will ultimately filter through to UK consumers in the coming months,’ cautions AJ Bell’s Russ Mould.

April’s 2.4% rise in the CPI measure of UK inflation was softer than the 2.5% expected but the rising cost of living pace could easily ‘pick up in the next couple of months,’ believes Andrew Sentance, senior economic adviser at PwC.

‘The general direction [of interest rates] remains upwards, given negative real interest rates; it is more a question of timing,’ says the UK equity team at OLIM Investment Managers.

WHY YOU NEED TO CARE ABOUT US TREASURY YIELDS

Earlier this year the yield on US Treasuries (aka US government bonds) exceeded 3% for the first time in four years.

Heightened expectations for inflation in the US spooked holders of bonds as rising prices erode the value of the fixed coupon payments they get from the bond. This put negative pressure on prices and pushed yields higher.

When interest rates are increased as monetary policymakers respond to inflation, the yield on shorter term debt also goes up.

Eventually the point at which the yield on the two-year Treasury exceeds that of the 10-year has historically signalled a looming recession.

At the time of writing the two-year yield stood at 2.55% and the 10-year yield was 3.01%.

Higher bond yields have negative implications for equities. Higher borrowing costs for companies can result in less cash to invest for the future and to return to shareholders through dividends, or potentially result in firms going bust if they can’t service their debt.

The higher yield available on low-risk bonds can also draw capital out of higher-risk equities. The yield on the S&P 500 is currently less than 2%.

Patrick Thomas, investment manager at Canaccord Genuity Wealth Management, says: ‘There are probably three prices that really matter to global investors – the dollar, oil and the 10-year Treasury yield.

‘Surging dollar and oil prices along with Treasury yields popping have been fairly ominous signs for UK investors in the past.

‘Think 1973-1975, 1979-80, 1989-90, 1999-2000 and 2006-2007. The UK cannot be insulated from rises in global funding costs.’

OIL – THE GLOBAL GROWTH ENGINE

Oil is one of the key engines of economic growth and as such prices are closely linked to the fortunes of the global economy.

Although big claims have been made for an electrical vehicle revolution, it is products derived from crude oil which fuel most of world’s transportation. Oil is also used for power generation and the manufacture of plastics and other products.

Geopolitics, including recently tensions over Iran and instability in Venezuela, has had an impact on oil prices as traders react to the impact on supply, helping drive the global benchmark Brent to $80 per barrel. This recent surge might begin to undermine demand.

The International Energy Agency recently commented: ‘As the International Monetary Fund noted recently, the global economy is doing well. Therefore, we remain confident that underlying demand growth remains strong around the world, which has been an important factor in the rise in oil prices.

‘Still, the fact is that crude oil prices have risen by nearly 75% since June 2017. It would be extraordinary if such a large jump did not affect demand growth, especially as end-user subsidies have been reduced or cut in several emerging economies in recent years.’

Copper is also a good barometer of the world economic picture, to such an extent that the term ‘Dr Copper’ has been coined. This is largely due to its ubiquity. The metal is a critical component in the manufacturing of electronics, homes and infrastructure.

Copper prices have risen by 22% since June 2017 to $6,867 per tonne; and they’ve increased by 52% since June 2016.

HOW EXPENSIVE ARE EQUITIES AT THE MOMENT?

Many investors like to use Robert Schiller’s cyclically-adjusted price-to-earnings (CAPE) ratio to gauge whether a market is cheap or expensive.

It is the share price divided by the average of 10-20 years of earnings which in theory should help smooth out the impact of peaks and troughs in the business cycle.

Unfortunately this ratio may not be entirely suitable to assess whether the market has got ahead of itself.

Phillip Hoffman, investment director of Pzena Investments says the CAPE ratio has definitely been screaming over-valued for some time. However, he makes the point the Schiller’s original work was only ever meant as an indicator of long term returns for the market. ‘I don’t think it was ever meant to be a short-term market timing tool,’ he comments.

Duncan Lamont, head of research and analytics at Schroders, last year said when the Shiller PE was high, subsequent long term returns were typically poor. ‘One drawback is that it is a dreadful predictor of turning points in markets. The US has been expensively valued on this basis for many years but that has not been any hindrance to it becoming ever more expensive.’

Perhaps a better way to gauge the market’s valuation is to look at forward PE ratios, namely how current share price match against earnings forecasts for the next one and two years.

The FTSE 100 is currently trading on 14.09 times the current financial year’s earnings estimates versus an approximate average of 13-times over the past 15 years.

In comparison, the S&P 500 in the US currently trades on 17.01-times versus a historical average of 15-times.

HOW CONFIDENT IS THE UK CONSUMER AND WHY DOES THAT MATTER TO INVESTORS?

UK living standards are starting to rise again in a boon for consumer confidence, although rising petrol prices mean disposable incomes remain pressured and retail sales data is volatile at best.

GfK’s Consumer Confidence Index highlights confidence remains fragile with the index decreasing by two points to -9 in April for a
28th consecutive month without a positive overall index score.

However, retail sales rose by a better-than-expected 1.6% in April as consumers resumed spending following a long period of unseasonably cold weather. In March, sales had fallen by 1.8% and recorded their biggest quarterly fall in seven years, according to figures from the Office for National Statistics.

Mike Bell, global market strategist at JP Morgan Asset Management, says retail sales are highly correlated with consumer confidence and wider consumption which makes up a significant part of UK GDP.

For those investing in the FTSE 100, Bell stresses that global growth matters more as the majority of revenues for the largest UK companies come from abroad.

But if you own shares in UK domestic businesses, the state of the UK economy and consumer confidence levels are extremely important to
your investments.

Put simply, more jobs and higher pay feed through to increased spending which should boost corporate earnings – the latter is a key driver of share prices. In contrast, a weak economy and worried consumers can lead to reduce spending which hurts corporate earnings.

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