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Woodford IM: Is a stock market correction on the cards?

Mitchell Fraser-Jones, head of communications at Woodford Investment Management, discusses the current mismatch between ultra-low bond yields and roaring global equity markets.

Lauren Mason

By Lauren Mason, Senior reporter, FE Tru...
Monday February 13, 2017

The UK stock market will continue to achieve attractive returns as 2017 progresses, according to Woodford Investment Management’s Mitchell Fraser-Jones, despite concerns that ultra-low bond yields and roaring equity markets are pricing in two very different scenarios.

While investors may worry that equities are currently overvalued, the head of communications says they are reasonably priced on a historic basis and, as such, the UK equity market could still reward those with skin in the game.

“Financial markets appear to be sending mixed signals. Ultra-low sovereign bond yields around the world imply that bond markets fear the prospect of continued economic stagnation. Meanwhile, global stock markets are near all-time highs and market leadership suggests that a reflationary economic recovery lies just round the corner,” he wrote in Woodford Investment Management’s latest blog entry.

“Both can’t be right but does this suggest that equities are overvalued? Is a UK stock market correction overdue?

“Answering these questions would, of course, rely on a prediction of what may happen in the short term and you shouldn’t expect to see such a thing on these pages.

“From a longer-term perspective, however, we continue to believe that the UK stock market can deliver attractive returns from here,” he noted.

Equity markets across the globe thrived throughout a majority of 2016, following last February’s market correction after commodity prices began recovering.

In terms of sentiment, though, it was certainly a year of two halves, with the first six months of strong equity returns being dubbed as one of the most hated bull markets to-date.

In the UK specifically, the plummet in the value of sterling bolstered many global-facing exporters while companies further down the cap spectrum struggled.

Following murmurs of fiscal expansion from chancellor Philip Hammond and, across the pond, from then president-elect Donald Trump, there was a violent market rotation from growth into value stocks.

This boost in investor sentiment led to the FTSE 100 index breaking through the 7,300 barrier for the first time ever at the start of the year. It then went onto achieve 12 new all-time highs and 14 days of solid gains.

Performance of indices in 2017

Source: FE Analytics

However, Fraser-Jones believes that UK equities still have further to run.

According to history, investors buying into the market when valuations were low has led to stellar long-term gains while, conversely, buying into stocks at high prices has led to lacklustre real annualised total returns.

Despite strong short-term returns from UK equities, Woodford IM’s research shows that valuations are actually fairly reasonable relative to history, as shown in the below chart.

P/E ratio of FTSE All Share vs 10yr real annualised total return since 1974 (inflation-adjusted)

Source: The Lazarus Partnership, Woodford IM

“The UK stock market’s current PE of about 15x this year’s anticipated earnings, implies a real annualised total return of approximately 8 per cent over the next 10 years, based on the historic trend shown on the chart,” Fraser-Jones said.

“This isn’t bad, in our view, especially when compared to the likely returns available from other asset classes.”

Generally speaking, though, the firm is cautious on its outlook for the global economy. As such, Fraser-Jones is more sympathetic towards the behaviour of the low-yielding bond market than the rallying equity market.

“First, market returns may well disappoint from here,” he explained. “We are confident that the relationship between valuation and subsequent returns will hold going forward, but the correlation is not perfect and is entirely plausible that the outcome sits to the left among the data points that have been below those predicted by the line of best fit.

“Indeed, it is probably no coincidence that the two most recent data points (starting in 2005 and 2006) are amongst the most disappointing outcomes we have seen in this relationship.”

Secondly, he warns the continuation of sluggish economic growth over the medium term could mean UK stock market returns are better in the second half of the decade than in the first half.

That said, Woodford IM believes UK equities are still able to offer investors attractive returns over the longer term, as long as investors are selective and do their research.

“Even in the dotcom bubble when the overall market was ludicrously overvalued, there were cheap stocks,” Fraser-Jones pointed out.

“Genuinely active fund managers were able to find ways to make attractive returns even though the broader UK stock market stagnated for the best part of a decade.

Performance of index vs sector since 2000

Source: FE Analytics

“Today, the environment is different but truly active fund managers, such as ourselves, can add substantial long-term value.”

The head of communications says that, at any given point, there is always a spread of cheap and expensive stocks across the market. As such, the onus is on the investor to avoid the richly-valued stocks and scour the market for the attractive opportunities.

“We remain confident in the UK equity asset class but believe we can do even better than the market and deliver very attractive returns in the long run,” he added.

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Data provided by FE. Care has been taken to ensure that the information is correct, but FE neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.

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