We’ve seen an impressive stock market rally since 23 March. The FTSE 100 is now up by more than 25% from the lows seen just over two months ago.
With most countries now exiting lockdown, investors appear to be very optimistic about the outlook for the economy. Taking a long-term view, I feel the same. History tells us we’re usually able to overcome most problems. However, I’m concerned that, in the short term, there could still be a lot of bad news to digest.
Hope vs reality?
The current stock market rally seems to be built on the hope that companies’ earnings will quickly return to 2019 levels. What worries me is that many haven’t provided profit guidance for the current year. They don’t know what’s going to happen — yet.
Over the next few months, the outlook should start to clear. When this happens, I think some of the numbers we’ll see will be worse than expected. This shouldn’t be a big surprise to investors.
However, the FTSE 100 is trading on 15 times earnings, as I write. This suggests to me that investors aren’t expecting major cuts to profit forecasts. So if we do get bad news later this year, I think there’s a risk the stock market rally could come to a sudden halt.
What about 2021?
It’s pretty obvious that many companies’ profits will be devastated this year. Retailers, travel operators, restaurants, and pub chains are all obvious candidates. They’ve had to shut down their businesses for two months and must now start up again under difficult conditions.
If things go well, many of these businesses could return to more normal trading in 2021, assuming social distancing requirements can be relaxed.
However, I think there’s a second, bigger risk we need to worry about. A recession seems likely, given the massive drop in economic activity that’s resulted from lockdown. Some businesses — such as airlines and car manufacturers — appear to be preparing for a longer period of weak demand. Several big airlines have announced major job cuts, as have some car manufacturers.
I think these cutbacks could drive a second round of bad news later in 2020, as industrial firms involved in these sectors (and others) warn of a fall in new orders and cut jobs. In turn, this could lead to rising unemployment and pressure on consumer businesses and housing, especially in the UK’s regional markets.
What am I doing in the stock market rally?
So what should you do? Personally, I’m continuing to buy FTSE 100 shares selectively, if I think they offer good value and long-term growth potential.
Sectors where I can see decent opportunities include some technology stocks, defensive consumer goods and luxury items. By contrast, I’m being more cautious about buying industrial stocks exposed to cyclical sectors, such as transport. I’m also staying away from property and housebuilders, except in London.
I won’t chase stocks higher that already look fully priced to me as I expect to see more volatility later this year, which could provide better buying opportunities. I think the secret to making money from this stock market rally is to be very selective.