The stock market rally looks set to continue in 2013

Central bank stimulus is only part of the reason equity markets have continued their recent upward trend

THE global equities rally of the last few months has left stock markets sitting at levels not seen since well before the collapse of Lehman Brothers in 2007. The FTSE 100 yesterday reached its highest point since late 2000, after closing up 0.48 per cent to 6,755.63. And markets elsewhere have seen marked upswings, with many witnessing near five-year highs.

The driving force behind the rally has partly been aggressive stimulus packages implemented by central banks across the globe, with investors piling out of government bonds and into riskier assets in response. And the FTSE 100’s performance last week has led Mike van Dulken of Accendo Markets to question whether another 200 point gain could be on the cards – taking it to its all-time high of 6,950, last seen at the end of 1999 when the Dot com bubble reached its peak.

But investor optimism is still puzzling. On the one hand, a recent University of Michigan survey found that consumer confidence in the US rose to 83.7 in May – its highest level since July 2007. Arguably, renewed economic confidence is pushing up corporate valuations. But such positivity sits uncomfortably against other measures. Since September 2011, global earnings per share have been flat, while share prices have gained about 30 per cent. And many analysts agree that recent market highs are fluffed up and artificial. “It doesn’t make sense for the Dow Jones Index to be at 15,000, or the FTSE 100 at 6,700,” says ETX Capital’s market strategist Ishaq Siddiqi.

As such, investors are bracing themselves for a correction. When and what will drive it is less clear. Siddiqi points out that corporate earnings are still beating expectations, despite a poor economic backdrop. Partly this is due to how companies have reacted to the difficult environment. Blue chip corporates have undertaken management reshuffles, de-leveraged and shed toxic assets, particularly across the banking sector. And investors are now telling corporates that they need real returns, driving companies to get involved in deal activities – like Yahoo’s $1.1bn (£720m) acquisition of Tumblr – to buy back shares, or to return dividends to shareholders.

Far from blind optimism, Siddiqi thinks that this positivity is justified – for now at least. “Currently, there is a lack of incrementally negative news to act as a catalyst for a correction”.

Nonetheless, van Dulken highlights some key considerations for traders. Tomorrow Fed chairman Ben Bernanke will go before members of the US Congress with an update on the economy. His comments will be closely scrutinised for any clues about the future direction of the Fed’s monetary policy – namely any adjustment to its quantitative easing pace, which currently stands at $85bn per month (as announced in December last year).

But van Dulken thinks any change in policy at the Fed is unlikely, with inflation in the US still benign, and unemployment not yet beneath Bernanke’s target of 6.3 per cent. Similarly, Siddiqi warns that Germany’s elections in September could shake up European markets, but that a change in the status quo is highly unlikely.

So what should traders be considering? “A bullish but picky approach,” says Siddiqi. He suggests that we are going through a sector rotation as investors start to shun defensive sectors (utilities, telecommunications, food and beverages), in favour of cyclical and higher risk sectors like industrials or banks. The latter sectors have been hit hard recently, but now could be a good time to enter the market.

Similarly, the auto industry has not fared well in recent years, but now presents a good entry point – Siddiqi highlights Volkswagen and BMW in particular. And with a lot of FTSE-listed companies having relatively small connections with the UK itself, there is scope to turn bullish on those companies with good exposure to the US – like Pearson or Wolseley.

Trading in this environment requires the usual due diligence. And van Dulken warns to be aware of the major levels on the indices. “Most clients want to invest in the big names, but they need to remember to keep a very close eye on what their chosen index is doing. Because if it’s under pressure, those big names will be too.”

Is it all good news? The appetite for equities looks set to increase, as they are currently yielding more than their alternatives. And bond yields are still depressed. “The bond market is still huge, so an exodus would mean a lot of money that needs a home,” says van Dulken. Siddiqi is not alone in thinking systemic risk will rock the boat, but with a target of 7,200 on the FTSE 100 by the end of 2013, around 17,000 on the Dow, and 8,700 on Germany’s Dax, he isn’t alone in feeling bullish about the stock market this year, either.