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If this were to happen, it would signal the likelihood of a return to long term bear market conditions, and some commentators have suggested we will again visit the dark days of sub-4000 on the FTSE. This seems rather premature, given that we haven't as yet seen wholesale changes to interest rate policy, corporate earnings expectations and inflation in the UK. But the fears cannot be dismissed, and it is often the case that markets lead economies, rather than the other way round. So we will watch closely, but for the time being, the area between 5510 and 5560 is crucial, and a conceivable next target area for holders of short positions.
Blue Index clients who follow our morning reports will know we have been bearish since the trend turned down decisively on 11th May, and until we see a decisive technical change to the upside, the advice remains - sell into strength.
Inflation and share prices
As the last twenty years have witnessed generally disinflationary conditions, there is a generation of investors who are not really aware of the period from the mid 1960s to the early 1980s, when high inflation was a fact of life for many developed economies. It comes as no surprise then that the subject of inflation and its effects on market returns has returned. This is in no part due to Ben Bernanke's comments to the effect that the Fed needs to be vigilant to make sure inflation stays under control. But what does it really mean for equities?
The relationship between the two is quite complex. The traditional view is that stocks are a good long-term inflation hedge, because when inflation is high, companies are able to raise prices which goes straight to the bottom line, so real (after inflation) earnings growth should be unaffected. When measured over several periods, this is relatively constant, and nominal earnings growth generally fluctuates with inflation.
But of more concern is the effect of interest rates, which as Bernanke has intimated might have to rise further to combat inflationary pressures. This creates two problems: first, the equity risk premium rises, such that investors require higher perceived returns for equities in their asset allocation models when measured against risk-free cash, and second, real economic growth rates tend to be lower in high inflation economies, which impacts corporate earnings growth.
Both of these factors usually lead to a contraction in p/e ratios and a rise in equity dividend yields, which is what happened the last time round. The Dow Jones Index traded a wide range for 18 years, ending in April 1982 where it was (around 760) in 1964, a disastrous performance for long term holders of US stocks at the time, given that inflation raged at up to 20% p.a. at times.
An easy way to hedge equity risk
Until recently, investors had to suffer in silence when stockmarkets endured major falls, and many clients will be aware of the period following the dot-com boom, when the FTSE fell 50% top to bottom, and there were even worse falls in the Nasdaq (see chart) and other indices. So if you believe we might have some years of turbulence ahead of us, one way to insure against this nowadays is to use index CFDs, which are easy to execute and provide immediate and cheap hedging opportunities. Quite simply, you can treat the FTSE 100 index, or any index for that matter, the same as a share price. CFDs should really be seen as a valid part of investment hedging, and our website provides several walkthroughs for new clients.
CONTRACTS FOR DIFFERENCE (CFD) TRADES TO WATCH NEXT WEEK
SELL GUS
TICKER: GUS
TARGET: 4% plus
UK
STOP: 2%
TECHNICALS: The most recent rally in April formed a lower top for the first time, and the shares have now broken decisively below longer term moving averages. Following the break below previous support around 910p, the next level to look for is 850p, then 810p. Stops should be placed above yesterday's high at 921p.
LATEST SIGNIFICANT FUNDAMENTALS:
Pre-tax profit before exceptionals fell to £829m from £910m last year after the disposals of Lewis, Burberry and Wehkamp during the year. Turnover rose 9% to 7.3bn, while pre-tax profits came in flat at £649m. DIY group Homebase saw earnings before interest and tax slump to £51.8m from £113.8m last year. At Argos, operating profit for the year was down to £291m from £320m. Credit checking arm Experian had a record year with profit up 29% to £416m. The group added that ARG and Experian will be demerged in October 2006. GUS investors will own the majority of both companies though it expects to raise about £800m through the issue of new shares in Experian when it demerges. New investors will be offered a maximum of 5% of Experian's ordinary share capital. The full year dividend will rise to 31.5p from 29.5p last year.
RISK AND DURATION INFO:
10 Day Trade Plus
Risk 7/10
Trade Rating 8/10
BEST CASE SCENARIO: Below major support at 810p
NIGHTMARE SCENARIO: Above 200 day moving average at 980p
