BLOG: High cash weightings give scope for further stock market gains

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According to the US financial services group State Street, individuals with investable assets have raised their cash allocations significantly over the past two years. In the UK, State Street found that cash allocations had risen to a surprisingly high 43% in May.

A similar phenomenon was found across a broad number of developed countries, with Japan right at the top. Japanese retail investors were holding 57% of their assets in cash last month, despite miserly domestic interest rates.

This is important because one of the arguments for an imminent peak in stock markets would be a lack of investor firepower. In other words, when there’s no more cash investors can commit to stocks, the only way is down.
Today though, virtually the opposite appears to be true. The reason for this may be that, since the turn of the millennium, investors have weathered three major crises: the boom and bust; a further plunge in stock prices after 9/11 and then the onslaught of the largest failure of financial engineering in living memory.

Each time, shares have bounced back, but each time the sharpness and severity of the preceding market falls will have left an impression.
The net result of the market gyrations we have seen since 2000 is that the FTSE 100 Index is broadly back where it started (provided we take no account of the dividends paid by FTSE-100 companies over the past 14½ years).

This leaves us in something of a quandary. Is the UK stock market worth no more than it was 14½ years ago (a bit less in real terms, if you take account of inflation). Or was the market so overvalued at the end of 1999 that such a comparison is fruitless?

One view is that, after five years of rising stock markets, a significant market correction may be in sight. There is a logic to this. It’s rare for markets to rise year after year without a setback or two along the way.

Moreover, even if economic growth remains strong – as in the UK currently – or improves further – as looks likely in the US – and corporate earnings continue to grow, how much of this good news is discounted in share prices?
As a guide, we could look at current valuations. One way of doing this is to consider the prices of shares in relation to their issuers’ annual earnings.
For the FTSE 100 Index, the multiple of share prices to reported annual earnings over the past year (the so-called historic price-to-earnings ratio) is a reasonable-looking 14 times.

One further positive for the UK stock market – and the reasoning here is a bit like the conclusion we might draw from knowing about high levels of cash sitting out the summer on the sidelines – is that there are a number of well-documented reasons to be fearful.

Take the past couple of weeks, for example: The Governor of the Bank of England, Mark Carney, sent ripples through markets from his podium at the Mansion House, by hinting that interest rates might be raised sooner than markets expect.

On top of that, there has been a sharp escalation of the current crisis in Iraq – a brewing situation with possible global ramifications.

In a sense, this feels a bit like a phoney market correction, with investors poised for disappointment. History suggests that’s bull markets don’t end this way – they end in a euphoric consensus that all is well.

Perhaps then, we ought not to be too surprised if the market reaction when interest rates go up is more unpredictable than many fear. As ever, the greatest threat will likely prove to be something the very few as opposed to the very many have been expecting.

Maike Currie is associate investment director, Fidelity Personal Investing

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