We could be in for a big market correction. The Dow Jones Industrial Average slipped around 2.5% on Friday and is around 4% lower over the past week.
Maybe this move could lead to something bigger. The major market indices in the US went parabolic over recent weeks with the valuations of many constituent stocks looking stretched. It’s been a long time since markets corrected in a meaningful way, and many investors think a big correction is inevitable at some point.
Where the US markets go, the UK tends to follow
To me, ‘right now’ looks like a good time for, say, a 20% or 30% correction in the US market indices. And where the US markets go with the big moves, the UK markets usually follow. Although the magnitude of the correction could be smaller in Britain, because UK firms generally appear more modestly valued and their indices have not gone parabolic.
With such corrections comes opportunity. I’m long-term bullish on the prospects for British firms and for the London stock market. My belief is that, over a period measured in decades, we are likely to see a big uptrend ahead. However, I reckon that we currently have pockets of over-valuation, particularly with cash-generating, dividend-paying defensive firms. These are my favourite London-listed stocks for long-term investing.
If a decent correction arrives, I’ll be looking for opportunities to buy better value in firms with great defensive businesses, such as cigarette maker British American Tobacco (LSE: BATS), premium alcoholic drinks supplier Diageo (LSE: DGE) and fast-moving consumer goods operator Unilever (LSE: ULVR).
Valuations too high?
Defensive firms can be popular with investors in uncertain economic times, such as we’ve seen in recent years since the credit crunch. We’ve also seen the ‘bond-proxy’ trade where investors have bought shares in steady, defensive, dividend-paying firms, That’s because the dividend yields have been higher than the interest available from bonds and from savings accounts. All this drove the valuations of defensive firms higher. But what goes up, often comes down, and I think a market correction now – against a background of rising interest rates – is just what we need to cause the valuations of defensive firms to cycle down again.
So, I’ll be ready. However, as well as reasonable valuations, I’ll be reading investor sentiment by looking at these firms’ share price charts. I would like to see some kind of basing to indicate that the share prices have stopped falling. To me, it makes no sense to buy an obviously still-falling share price, even if the quality and value metrics stack up.
This chart is a snapshot of what these three stocks offer in terms of value and growth forecasts today:
|
Company |
Share price |
P/E ratio |
Dividend yield |
2018 EPS growth |
|
British American Tobacco |
4,672p |
17 |
3.9% |
12% |
|
Diageo |
2,479p |
22 |
2.6% |
8% |
|
Unilever |
3,965p |
21 |
3.2% |
10% |
My ideal scenario would to be to pick these great stocks up with yields above 5% and price-to-earnings (P/E) ratios in the low teens. That said, I think they are all capable of making decent long-term investments with the potential to work out well even if your share purchase misses the low point of on any correction that materialises.