Market catapulted higher on Brexit induced sterling weakness

Current Overview

The market has reached new highs, not just the closely watched FTSE 100 index but the less well known FTSE 250 also, the index which most saw in free fall immediately after the Brexit vote in June. Yes, the mid cap index (as the FTSE 250 is often referred to) which represents a more realistic spread of UK aligned businesses which were meant to crater on the news that we are leaving the EU. But before we reach for the champagne to toast this “bucking Brexit”, “markets only rise” environment we seem to have arrived in, let us take a measured step back to assess matters.

Record low interest rates are continuing to lure capital into equities where investors are seeking (chasing maybe) improved returns. The value of the pound has fallen to renewed lows as the start date for formal Brexit negotiations has been announced for next March. This weaker pound is indeed very good news for all UK listed companies with significant profits coming in from overseas (non sterling geographies). Moreover weak sterling means UK companies (shares) are cheaper to buy for investors outside the UK. I understand the cause and effect of this buying dynamic but it doesn’t mean stocks will simply keep rising. Market investing is never that easy and for how long will these current FX rates prevail.

In reality, markets have actually been trading sideways throughout the summer. Volatility intraday has been very low and while I do not necessarily agree that investors are complacent (they are aware of numerous risk variables), I nonetheless find myself increasingly anxious that trouble is brewing. The sentiment that “there is nowhere else but shares to put one’s money” I regularly hear. Savings accounts pay nothing and bonds are already ludicrously overbought, many now with negative yields. There seems almost a curious calm in the markets and my alarm bells are starting to ring quietly.

Last summer, Chinese growth concerns brought about double digit declines in indices in what was a mini crash and genuine wake up call to the capabilities of risk assets. Yet all has been quiet on the Eastern front for some time. What has happened to the worries that Chinese growth is contracting fast or that debt levels look worryingly high in what is the second largest economy in the world. When was the last time the market had to deal with Chinese currency devaluation? The point is that China maintains its ability to bring about volatility if even on a short term basis.

My current belief is that the serenity is soon to crack. It is the season for it in markets; let’s just start with that. US interest rate rise nerves, bubble like bond markets, an impending US election and now a creaking acceptance that Brexit will happen, may all be contributory factors. It is too early to say Brexit will not bring about economic problems globally and too arrogant to say Trump won’t get in. Just a growing feeling that he may could bring about equity market falls.

Finally, market valuations. While US economic data continues to be resilient as do forecasts for global growth, equities are not cheap even if they are not necessarily expensive on valuation metrics. Most often this might be Price to Earnings multiples for stocks. The S & P 500 index of the US trades on around 30 times forward earnings which is dear if corporate profitability levels were to falter. Current valuations just make it hard to see why shares will necessarily rise much more in the near term. Similar valuations can be found across the FTSE 100.

Market specific comment

It will come of little surprise that I am holding cash balances on portfolios for many of my clients. I have been raising funds from the aforementioned dollar earning stocks into strength and from some generalist equity based Investment Trusts many of which are trading at all time highs. I have also been selling in the corporate bond space to free up cash even where bonds were initially bought to be held to redemption. I feel this can only be prudent risk management. To stress I am only looking to hedge my bets over the short term and I am not necessarily calling the onset of recession or an extended period of market weakness.

Notwithstanding my current generalist position on the market, I am constantly seeing out opportunities in stocks where I believe value and upside potential is apparent. Even if the overall market may fall, it does not necessarily mean all individual stocks will fall as much as others (if they fall at all).

Consider Go Ahead Group (2020p) in the mid cap transport space. The valuation is depressed by the fiasco that is Southern Rail (they have a 65% share) but they run London Midland and South Eastern too. The company is the market leading player in London buses with a 25% share and a significant regional operator too. The current market capitalisation at 880 million GBP is around 8 times the operating profit of the Bus division only and thus the Rail Division is seemingly in the valuation for free. This seems harsh to me and with a growing dividend yield of 4.75% and low levels of net debt, I suspect this stock has contrarian appeal. Results last month were slightly ahead of expectations and the shares have dipped from the 2200p level just 4 weeks ago and are down from 2700p in the Spring.

OneSavings Bank (280p) in the challenger space also warrants some investigation. A 700 million GBP market value brings a near 4% dividend yield and a very attractive forward PE valuation of around 7 times forecast profits. In August the company reported a significant 36% increase in underlying profits to 64.6 million GBP and re-iterated the quality of its balance sheet. Specialist focused lending in buy- to-let and mortgages are core as are attractions as a retail savings institution. While growing net interest margin for all banks is a significant challenge, a countering balance is the clear and formidable ongoing opportunity to gain market share from disillusioned big bank customers.