The FTSE 100 index of the largest companies listed on the London stock exchange closed below 7,000 last week after flirting with 7,800 as recently as August. That’s a big pullback, so what might be going on? Here’s what I think.
The share prices of the companies within the index are usually driven by earnings. Generally, if a company reports higher earnings, its share price will rise, and if it reports lower earnings its shares will go lower. However, because investors look ahead and buy or sell shares accordingly, they tend to move higher or lower when investors, as a whole, think earnings will rise or fall in the future. When that happens, we tend to talk about investor ‘sentiment’ driving the market.
The market hates uncertainty
When we talk about the stock market, we are really talking about the weight of all the investors participating in buying and selling shares. And one thing the stock market hates more than anything else is uncertainty because it worries about events affecting the ability of companies to maintain or grow their earnings. So, in times of uncertainty, the market tends to assume the worst – that earnings will fall – and so marks down share prices. If the shares within the FTSE 100 fall, the FTSE 100 index will fall as well.
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Reason 1
Right now, we have several things causing uncertainty and negative investor sentiment. Perhaps the biggest is the tortuous unfolding of the Brexit process. If nothing else, I reckon Brexit could be keeping a lid on the share-price progress of many companies. Underlying operational progress and advances in annual earnings are often being ignored by the market because it doesn’t know what effect Brexit will have on the firms’ underlying businesses in the future.
Reason 2
Another uncertainty could be the threat of rising interest rates. Governments often raise interest rates to slow down economies if they are getting overheated. The overheating often shows as inflation, so interest rate rises encourage more saving, which helps to control inflation. But higher interest rates can make it harder for businesses to grow earnings because the higher cost of borrowing can reduce investment and output.
Reason 3
I think the biggest factor affecting the FTSE 100 is that markets in America have been falling, such as the Dow Jones Industrial Average (DJIA), the NASDAQ Composite and the S&P500. There’s a long tradition of the stock market indices in Britain following those in the US, particularly when it comes to big moves down.
The market could be worrying too much
Soon though, we will know more about the path Britain will take when it leaves the European Union, and a big chunk of uncertainty will be removed. My belief is that the FTSE 100 index will respond well to that. I also think it will dawn on investors that if interest rates begin a slow ascent, it will actually be because economies are doing well, which bodes well for company earnings. And if economies are doing well, and companies are doing well, the American stock markets are likely only experiencing a correction from an over-valued state, and we are probably not seeing the beginning of a sustained bear market for shares. To me, the FTSE 100, and shares in general look attractive on the London stock market, and I’d use this pullback as a buying opportunity.
