The market has been on an outstanding streak as of late. Shrugging of Brexit and an interest rate rise in the USA to get close to its all time 7000+ high last Thursday. But, I feel that the market is about to enter an exciting period of decline.
Finally, it seems that common sense is prevailing and the market is waking up to realise that it’s grossly over valued.
JUST TAKE A LOOK AT THE FTSE’S 5 YEAR P/E!
As we can see from the above graph, the FTSE’s price to earnings ratio has spiked massively from bumping around under 15 to over 35.
Simply put, the FTSE has been driven by demand as opposed to underlying earnings growth from its constituents.
A quick glance at some FTSE constituents valuations will further illustrate the eye watering prices being paid by investors for stocks in pursuit of yield and in hope of earnings growth.
Brexit will smash high p/e stocks.
Investors have shaken of Brexit nerves but this is only relative to pre-brexit market levels that were already overvalued. (As shown on the FTSE 100 5 year illustration above)
When investors buy high p/e stocks they are buying future growth prospects. These prospects and material. Simply best guesses. When these don’t deliver, these stocks will tank.
Why?
Consumer confidence has dipped since the Brexit vote but action by the BoE has helped steady nerves.
With a clear decline since Brexit, BoE action has led a recovery in consumer confidence since then, but confidence remains in negative territory.
Further to this, Brexit hasn’t even happened yet and the full effects of the vote are yet to be realised.
I believe that investors are relying on a false self sense of security simply hoping that the UK will get a good deal and that BoE action will avoid a recession. BUT, once article 55 is triggered and the negotiations properly begin consumer confidence will once again decline.
When consumers lack confidence they don’t tend to spend money on non-essentials. Instead, they consolidate.
With less money being spent by consumers, inflated p/e ratios suddenly become harder to justify as uncertainty weighs on forecasted earnings.
Just look at what happened to ABF’s share price on the news that Brexit related events would weigh on profits;
So what do these two things have to do with each other?
The first section of this article outlined that the FTSE 100 was grossly overvalued on a historical basis even before Brexit.
The second section of the article outlined declining consumer confidence that will lead to lower consumer spending. With lower spending and more economic uncertainty due to Brexit, high p/e stocks will find it hard to meet their forward valuations.
Applying this logic one could conclude that the FTSE100 will find it hard to justify its high valuation and correct to a more historical average of a p/e ratio of around 15.
Kicking the FTSE while it’s down?
Another worry for the FTSE lies across the atlantic, in the USA.
I have argued for quite some time that the FTSE’s valuation is also being propped by income seekers buying high yielding stocks. This is why I sold BP.
Although future rate rises keep getting kicked down the road by the federal reserve, great unemployment data from the USA may lead to a rate rise sooner rather than later.
If US rates were to rise, investors may begin to switch their money from these risky high yielding stocks to safer bank accounts to fulfill their appetite for capital appreciation.
Conclusion
The lesson remains, never try to time the market. Even with p/e ratios this high, I have still been buying.
But, I think the declines of Friday and Monday are exciting signs of a correction that will hopefully lead to an over reaction on the downside for many excellent, but pricey, dividend stocks!
I’ve got my eye on picking up some stocks;
USA stocks: JNJ + MCD
UK stocks: RB, ULVR, WHTB
Don’t panic! This is an exciting time for dividend investors. TIME TO GO SHOPPING!