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What are the chances the FTSE will reach 50,000?

22 August 2016

Following a very bearish view of financial markets, Jim Wood-Smith – head of research at Hawksmoor – plays devil’s advocate and assesses the potential bull case for equities.

By Jim Wood-Smith,

Hawksmoor

The concept of balance, or duality, appears throughout history.

Religions teach of good and evil, Daoist philosophy of yin and yang, Buddhism of the middle way, Isaac Newton of equal and opposite forces.

After last week’s column, I was outed as a ‘bear’; it is only fair and proper therefore that today I should lay out the bull case. And as Sid James almost said: puer, O puer, O puer, is it bullish.

We need to embark on a little trip. So please clunk click, open the lemon sherbets and settle in for a little sight-seeing tour. And as a very quick tangent, I am in a state of over-excited anticipation awaiting BBC4’s latest ‘slow’ programme: the two hour bus journey from Richmond to Ingleton. Now that is my kind of television.

Never mind, on we must go. On into a world that the jargonistas refer to as ‘yield compression’.

Performance of 10-yr UK gilt yields over 10yrs

 

Source: FE Analytics

There are a number of important assumptions that we need to get out of the way at the outset. Please don’t blame me if you disagree, they are only assumptions that frame a scenario. And you should get out more.

However, we need to imagine a world in which inflation is zero, or thereabouts. Give or take a commodity cycle or two.

A world in which zero inflation perpetuates zero interest rates. A world in which zero inflation and zero interest rates result in zero sovereign bond yields and quantitative easing. A world that we might all recognize if we squint hard enough and tilt our head to one side.

Now here comes the interesting bit.

It is an open question: in this world, what is the sensible and logical yield for all other assets? Should it not be that the yield on all assets should move towards zero too?

If you can buy gilts, which after costs and taxes, are going to return you less than nothing, why can you still buy good things on yields of 2 per cent, 3 per cent, 4 per cent or 5 per cent. Or more.

What is the merit of an index-linked gilt that is guaranteed to return less than inflation (from current prices), when you can buy a utility promising inflation-matching dividend increases and a starting yield of 5 per cent? Incongruous springs to mind.

If, and this is an if bigger than the finale of Lindsay Anderson’s film (Boys! Boys! I understand you. Listen to reason and trust me. Trust me!) this world continues, then equities are cheap.

Spectacularly cheap. As cheap as they were at the bottom of every bear market that you can remember.

Trust me. If gilt, and other bond yields, are staying at zero then equity markets are not just going to rise, they are going to rise by multiples of their current levels.

When I were a lad, a wee whippersnapper with scabby knees and a snotty nose, equities were deemed to be expensive when they yielded half that of gilts. Let’s assume just for now that the 10 year gilt yield of 0.5 per cent doesn’t change for a while. The FTSE 100 dividend yield is currently, for the sake of argument, 3 per cent.

Some very complicated mathematics says that, if dividends do not change, then to yield a little less than gilts the market needs to rise by a factor of eight. Yes, eight. That makes, again give or take, the FTSE 100 at 50,000.

I know you all think that I am on acid (and crossed the diamond with the pearl).

It is only a scenario, not a prediction. But it is no more far-fetched than someone 10 years ago saying that the gilt yield would be 0.5 per cent.

It has its attractions to government too. It means an awful lot of the country can pay off their debts; it most certainly cracks the pension problem. In fact, if the stock market can be inflated without that translating into the high street then we are all, as they say, orf to the races.

Puer! O puer! O puer!

But never mind, we know that it is not going to happen. It can’t. Possibly. Can it?

No-one is saying this is even on their radar screens. Or inter-planetary radioscope. All the very clever people are saying that markets and economies are all going to end in the most terrible tears again and we need to pack our overnight bag for a paddle across the Styx.

Actually, that is not quite true: some very, very clever people are saying that this is a possible scenario, just not a terribly likely one.

Next week we have a break for the last bank holiday before Christmas. Then we are into the long slog through the autumn.

When you’re down and weary, and need a helping hand, just remember this week’s column and smile; thinking that some lunatic raised even the possibility that just maybe equity markets were going to go up.

 

Jim Wood-Smith is head of research at Hawksmoor and writer of the group’s weekly ‘Innovation’ blog. All the views expressed above are his own and shouldn’t be taken as investment advice.

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