As the UK starts to emerge from its latest lockdown, the FTSE 100 already trades above the levels reached just before the pandemic first made its presence felt in China and Southern Europe in early 2020.

There can be no finer example of how financial markets are forward-looking, discounting mechanisms which seek to price in future events before they happen.

Yet they are not right all the time. No-one owns a crystal ball and if markets really were that prescient then there would never be major selloffs or upward surges, as no-one would ever be surprised by anything.

Investors need to assess the facts as they are known, determine the current consensus about what will happen and – by looking at valuation – decide whether the risks are to the upside or downside.

They must look at the broad range of possibilities concerning what may happen, what could be the biggest surprises and their potential impact so they can decide whether the potential upside rewards outweigh the downside risks over their preferred time horizon.

The best long-term investors are not trying to guess the future. They are experts at probabilities and act according to the cold maths of valuation, be that measured by earnings, cash flow or yield.

It may not take much good news to boost a market that has fallen sharply to price in negative events, while it may not take much bad news to jolt a market if it has made big gains.

The FTSE 100 bottomed in late March 2020 at 4,994, long before the worst news about the pandemic and its toll on lives and the economy became known.

After a near-40% gain in the UK’s headline index over the past year, investors must once more assess the balance of probabilities so they can decide whether the index has further to run or not and a good place to start is earnings forecasts.

NEW HIGHS

At face value, it does seem odd that the FTSE 100 is trading above its pre-pandemic levels, even if the number of daily new Covid-19 cases are back to where they were last March and last September and the vaccination programme continues apace.

The economic outlook is still uncertain, the effects upon the behaviour of corporations and consumers alike are yet to reveal themselves, and other parts of the globe are less advanced in their race to inoculate their populations.

But it does make sense if you think that the consensus earnings forecasts for the FTSE 100 are going to be accurate. An aggregate of the estimates made for each member of the index suggests that the FTSE 100’s total pre-tax profit will be £178 billion in 2021 and £205 billion in 2022.

Those figures exceed the £166 billion made in 2019, before the pandemic hit home. Moreover, if the 2022 forecast is attained, then that would represent a new all-time high for annual earnings, surpassing the £199 billion made in 2011.

In this context, it is not to hard to see why the FTSE 100 is trading where it is, or even make a case for further gains, since the index trades below its May 2018 zenith of 7,779 even though record profits are expected for 2022.

Investors must therefore decide whether the forecasts are reliable, too optimistic or too pessimistic and what must happen for analysts to be on the wrong track.

HEAVY METAL

To do this, investors need to parse the FTSE 100’s earnings mix. Roughly 60% of forecast profits come from just three sectors: mining (now the single biggest earner), financials and energy (oil and gas).

In some ways, this makes it easy for investors to judge the upside and downside potential: in crude terms, the stronger the economic recovery the better, so far as the FTSE 100 is concerned as the index’s key industries offer huge gearing into GDP growth.

The opposite also applies. A weak recovery would be a nasty surprise.

A breakdown of forecast earnings growth makes this picture clearer still. Analysts think that the FTSE 100’s aggregate pre-tax profit will rise by £75.1 billion this year and by a further £27.1 billion in 2022.

Miners and oils are expected to generate two thirds of that amount between them in 2021. Consumer discretionary, oils and financials are forecast to provide four fifths of the expected profit uplift in 2022.

Rising commodity prices and steepening yield curves would therefore be a good sign, falling and flattening ones would not.

Investors who buy into the narrative that inflation is coming, after being largely dormant for 40 years, will therefore feel right at home in the UK. Those who still fear debt-ridden deflation may be tempted to steer clear and seek their fortunes elsewhere.

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