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It could be a long wait for markets to make recovery

Analysts are keen to project positive future expectations for the main market indices.

However, there is one important and serious reason why the main indices could tread water for a long time. It may be a long wait for the FTSE 100 to regain its high point of 6,930 on December 30, 1999. Anyone investing in index trackers or managed funds which closet track, in that they have similar exposures to the main stocks, are unlikely to do well as a result.

Conversely, truly active managers and those who concentrate on value are likely to do rather well as there remain plenty of attractive opportunities. To outperform these main indices could be rather easy and all for a simple reason, which it seems everyone has overlooked.

Technical reasons

The concept is simple. Most market indices are weighted according to the size of the component investments within them. This explains why over half of the value of the UK stockmarket is represented by the biggest 20 companies alone and why the likes of Vodafone and BP Amoco account for 25-30 per cent of the FTSE 100, depending on comparative values on any given day.

You may exclaim: “So What?” My prediction is that influences contrary to those which propelled the main indices to extreme levels through momentum investing and with a limited range of large growth stocks will now work in reverse. However, the reason for the decline is not because of any investment prediction (however appropriate) but simply because of the mechanics of a weighted index.

Let me explain through an extreme example. Just imagine that in the spring of 2000, at the height of the technology bubble, a South African-based technology and telephony giant decides to float on the UK stockmarket. At the appropriate next FTSE committee meeting, if relevant criteria are met, it would qualify for immediate inclusion, let us say, as the biggest stock on the UK market. Perhaps it counts for 15 per cent of the FTSE 100 index at that time and it displaces the smallest non-qualifier at the bottom of the list which counted for a negligible proportion of the index itself. Let us say that the index stood at 6,000 at that time and following the adjustment it counts for 900 of those points.

Let us now suggest that as the months develop, concerns begin to appear about the company&#39s wireless licence auction promises and the declining values of its sizeable bond issues which have covenants affecting the company&#39s equity too. As the concerns rise and the share price plummets, a warning of serious problems with its main technology sees the receivers appointed and the company goes bust.

Remember, this is not a prediction but an extreme analogy to illustrate the point which I believe is now inevitable. What this demonstrates is a situation where a component of the index which, upon inclusion, counts for 900 points of that index, yet within a relatively short while loses 900 points from that index and points which it never added on the way up.

So, what are the lessons? The technology/media/ telephony bubble was one of the most extreme the investment markets have ever experienced. By extreme, I do not mean spike in terms of performance but extreme in that, at the peak, these sectors counted for over 40 per cent of the world&#39s stockmarket capitalisation, influencing all markets and having an exaggerated impact on weighted indices. Had this excess arisen because existing companies had simply moved up the scales, so to speak, the impact on the way down would not have been so bad. However, so many overvalued companies came to the market at the time, qualifying for places high up the indices and displacing existing companies which dropped out the bottom. Not only this but many TMT companies became swollen in size as they expanded their equity bases.

Because of the excessive and ridiculous valuations of the technology sectors, existing stocks on the market increased in price by such leaps and bounds that because (quite rightly) the FTSE committees do not change the components on a daily basis, it meant that many qualifiers which had come up through the ranks jumped into the next index well up the rankings. Again, on the way down, this means points will have been deducted from the index that were never added to it on the way up. In many instances, because again the committee does not remove stocks daily, some of the technology losers have plummeted so fast that their equivalent market capitalisation size will have become so small that they will have stripped off points representing relegation to even a lowly position within the next index down.

Secondary reasons

A further reason why the main weighted indices are unlikely to make much progress is because they are dominated by so few business sectors. Oils, pharmaceuticals, banks and insurers, telecoms and technology count for around two-thirds of the value of the UK stockmarket. As an investment house, we are not enthralled by any of these sectors. In fact, there are reasons why oils are due to drift and why banks will slip if economic slowdown becomes inevitable (as is perhaps overdue regardless).

Pharmaceuticals are fully valued which might mean falls are due and technology and telephony – well.

This is simple mathematics which affect indices with components weighted according to their size (simply the number of shares in issue multiplied by current share price). Numerous investment products are connected to these indices and the herd-instinct implications are likely to become self-fulfilling prophecies, driving the indices down as sellers swamp buyers. At some point, the tide will turn and fundamental value will appear again, yet the excess of the technology bubble and the effect of unearned points being stripped away from the index as that bubble burst will still take a long time to repair from good old fashioned organic growth within share prices.

For further information, phone 01271 344300.

Philip Milton

Philip J Milton & Company,

Barnstaple, North Devon

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