In global terms, 2020 has been a rotten year for the FTSE 100 index, because it has underperformed most market indices. The FTSE 100 is down almost a seventh (13.7%) in 2020. In Europe, the Stoxx 600 index has lost 5.8% in 2020, beating the Footsie by eight percentage points. Across the Atlantic, the S&P 500 index has climbed by 12.9%, thrashing the FTSE 100 by over 26 percentage points. Why are cheap UK shares so out of favour? And could they rebound in 2021?
The FTSE 100 falls on fear
The first reason for the FTSE 100’s decline is the economic havoc caused by Covid-19. During our first lockdown, the UK experienced its steepest economic contraction in over 300 years. With the second lockdown getting tighter, investors fear another downturn and disappointing Christmas sales. Likewise, any further setbacks in 2021 would hit cheap UK shares.
The second problem is the prospect of a no-deal Brexit on January 1. Any disruption to business with the world’s largest trading bloc would harm our economy. Similarly, shortages and delays in the transport of goods could lead to price rises, pushing up inflation. In addition, if the UK crashes out of Europe on unfavourable terms, this might lead to a depreciation or debasement of sterling. This would be bad news for businesses heavily exposed to UK earnings.
The future will not resemble the present
Today, it’s easy to extrapolate problems into the future and be gloomy about beaten-down UK shares. But stock-market history is littered with turning points, partly because ‘reversion to the mean’ drives stock prices towards average valuations over time. For example, two months ago, value investing was dead and buried. Since Halloween, it’s enjoyed one of its best periods in decades.
However, I’m not Pollyanna, putting a positive spin on everything. From experience, I know full well that cheap UK shares can keep falling. Many will turn out to be value traps, waiting to ensnare unwary investors. Also, I’ve found that catching falling knives — buying steeply declining stocks — can be painful. I also learnt recently that the FTSE 100 has beaten the S&P 500 in only three of the past 25 years (2005, 2016 and 2018). Wow.
Cheap UK shares still appeal
I think cheap UK shares could make a comeback in 2021 because, in historical terms, they’re too lowly rated today. What’s more, FTSE 100 stocks derive roughly three-quarters (75%) of their earnings abroad. Thus, a decline in the pound’s relative value would boost these big businesses’ overseas earnings in sterling terms. That’s why I much prefer the FTSE 100’s international appeal to the UK-focused FTSE 250.
Lastly, others also see deep value in depressed FTSE 100 stocks. Several leading hedge funds, including Marshall Wace, have been bottom-fishing among these undervalued shares, as widely reported recently. Likewise, with UK shares out of favour, I expect 2021 to be a bumper year for M&A (mergers and acquisitions). I expect several FTSE 100 members to be bid for/taken over next year, following in the footsteps of RSA Insurance Group. With US private-equity groups awash with cash, the UK offers rich pickings and plenty of buying opportunities for opportunistic M&A fans. That’s why I’ll stick with cheap UK shares for 2021!