FTSE 100 – Where will it go next & how will the Election affect it?

So the FTSE 100 finally breached the almost mystical 7,000 point mark last week before returning below 7,000 this week. In fact, at its highest closing point it reached 7037.67 on 23rd March 2015. But what next for the FTSE 100? Will we see it go higher in the future or are there significant headwinds that could spark a longterm correction?

FTSE 7,000 - what triggered the rally

In my article from over a month ago, titled Stock markets at all-time highs, where next & should you buy?, I predicted that:

"if the FTSE 100 can break 6,930 the diagonal line of support could suggest that we’ll hit 7,000 pretty quickly".

Well that's exactly what happened albeit after a small sell-off. As I pointed out in last week's weekly note, a combination of factors came together to help push the index over the 7,000 line. They were namely a Budget which was positive for investors plus there were encouraging noises from central banks globally that the loose monetary policy (via money printing or low rates) is not going to let up anytime soon. Chuck in a soft pound which is good for exporters and the stage was set.

But does the level of the FTSE 100 really matter if you aren't invested in an index tracking fund? While you shouldn't obsess over the level of the FTSE 100 the return of the average UK equity fund is closely correlated to the fortunes of the index despite many funds investing in companies that are outside of it. The return of the average UK equity fund run by a manager has a correlation of 0.95 to the FTSE 100.

To put that into context a correlation figure can range between 1 and -1. A figure of 1 would mean that the return of the average equity fund exactly mirrors that of the FTSE 100. A figure of -1 would indicate that when the FTSE 100 goes up the fund would go in the opposite direction. While a figure of 0 suggests that they are completely independent of one another.

So if you are investing in UK equites, even via a managed fund, then the fortunes of the FTSE 100 matter.

Tailwinds

There are some definite tailwinds in equity markets generally which are proving supportive of shares. Firstly there is the accommodative monetary policy mentioned above and then the relatively soft pound which is good for exporters.

Consumer consumption has been given a boost by low oil prices as inflation has fallen to 0% in the UK. In addition the ISA season is upon us and this tends to be supportive of equity markets. In addition investors are seeing headlines about all-time highs in the FTSE 100 which can act like a candle to a moth, blindly attracting them regardless of the potential dangers.

The psychology of investing can not be underestimated and breaching the 7,000 mark broke the range trading (i.e. where the index bounces around within in a limited range) which has dogged UK equities for some time (see chart below - click to enlarge it).

Nothing encourages investors from the sideline more than the fear that someone else is making money when they are not. In that regard the 'great rotation' which has been expected for a number of years (where investors ditch safe assets to buy equities en masse) could start to materialise. In addition, a number of momentum indicators used by day traders are still flashing buy signals, at least for the moment.

Headwinds

Yet despite all this, at the time of writing, the FTSE 100 has fallen by more than 2%, back below the 7,000 mark. Weak data from China, political turmoil surrounding Greece and the airstrikes in Yemen have added to a sense of risk aversion that has hit markets.

The FTSE 100 has had a good run so far this year, up more than 6% despite the sell-off. In all likelihood, good old-fashioned quarter-end profit taking has no doubt had an influence on the FTSE 100's recent decline.

But will the sell-off continue? Probably, as a number of support levels have already been breached. Yet, as I highlighted previously, from a technical viewpoint there is a strong support level around 6,695 which I would be a little concerned if it was breached. If it isn't then the market should find a support to build upon.

Putting the global geopolitical risks to one side, there is a political risk to the FTSE 100 much closer to home. The outcome of next month's General Election will likely dictate the fortunes of the FTSE 100 in the short term.

To gain an insight into how it might possibly do so then let's look at how General Elections have affected UK shares historically.

The impact of a General Election on the FTSE

The FTSE 100 is a relatively new index (starting in 1983) so analysing its reaction to General Elections since then would only provide limited data. However the FTSE All Share (of which the FTSE 100 is one component) goes back as far as 1963. And to give you an idea of how closely the two are related the correlation figure between them is 0.99 (so they pretty much move together).

So how might the FTSE 100 fare in the coming months. Well the chart below, from the UK Stock Market Almanac, shows how the FTSE All Share has performed, on average, in the months leading up to and after a General Election (click to enlarge):

 

If history repeats then we should expect the FTSE 100 to fall by around 2% over the coming months.  A lot depends on the outcome and a drawn out period of uncertainty. If there is no clear winner come May then this is unlikely to prove positive for markets. But does it matter who wins? The Almanac chart below looks at the overall return for the entire election year in which an Election occurs.

On the face of it, a Conservative win is often positive for markets. But more broadly in 12 out of 17 Election years since World War II the market has gone up. In fact, the average return of the positive years is around 3%. Assuming a similar positive response after this year's election we'd be looking at a closing figure for the FTSE 100 of around 6,760 by the end of 2015, given that it started the year at 6,566.

So to sum up

In the short term the outlook for the FTSE 100 is pretty muted. As long as the index holds above 6,700, odds are that we likely to range trade for a while. To drive the FTSE 100 well beyond 7,000 (and it is a real possibility) company fundamentals need to catch up with valuations. In the absence of geopolitical events and uncertainty in the UK General Election that could spark a sell-off there is nothing to stop the FTSE 100 testing new highs this year.

 

Image courtesy of Michelle Meiklejohn at FreeDigitalPhotos.net