An ultra-bullish FTSE outlook is too optimistic in volatile times

AFTER a week in which the FTSE 100 dropped from its mid-April peak of 5,834 back down through the 5,000 mark, Morgan Stanley has surprised the financial world by revising its 2010 FTSE target up from 5,000 to 5,800. The bank suggests that recent market turbulence is not the start of the dreaded double dip but instead a repeat of the 1998 correction, in which the collapse of the US hedge fund Long-term Capital Management and the emerging markets debt crisis caused a 25 per cent drop in the FTSE before a solid recovery.

Morgan Stanley argues that the FTSE 100’s current 12 month forward price-to-earnings ratio is historically low at 11 times and, while it could drop further, it is more likely that it will climb closer to the 20-year market average of 14 times. “Historically, this series always troughs between 11-12, except in bear markets or periods of recession,” it says, and it is already below 1998 levels.

The bank highlights four factors that should contribute to a recovery: a low oil price, an improved financial system since 2008 and the likelihood that volatility prompts a delay in monetary tightening.

But others think this advice glosses over the recovery’s fragility. ETX Capital’s Manoj Ladwa expects to see the FTSE drop to 4,500 this summer before any sustained improvement. He says: “The recent rally that we saw in the equity market from late January to March was all very low volume and what we’ve seen in recent weeks is short, sharp sell-offs. There’s very little conviction buying going on out there.” This would suggest spread betters should wait to see the bottom of the trough.

Jeremy Batstone-Carr, head of research at Charles Stanley, agrees that Morgan Stanley is being overly optimistic: “Unlike the corrections of 1987 or 1998, this is not just a financial crisis but an ongoing global economic crisis in a post-bubble highly fragile state. If we are experiencing a recovery it is only very nascent.” He also suggests that any recovery will take at least until next year to materialise, forecasting a 50 per cent probability that the FTSE will end the year at 4,700 and a 25 per cent chance that it could dip to 4,300.

By contrast, Morgan Stanley predicts a maximum fall of 10 per cent to 4,400-4,500. The bank says that the publication of lagging economic indicators affected by the recent market drop might jolt confidence, but that continued monetary stimulus should counteract this effect.

And yet with many national governments struggling to get ballooning deficits under control, any bets relying on continued support could be risky. Ladwa says that the UK’s monetary stimulus will have to end soon to maintain our credit rating. While, “in the US they could probably extend it for a little while longer, I don’t think most parts of Europe can.”

Either way, traders who do enter positions now in the hope of a swift recovery would be well-advised to make sure they have a stop-loss in place to take account of continued volatility. With the range of estimates spanning 1,500 points, betters who get it wrong stand to lose big.