Outlook for the UK stockmarket

Should you think about investing or run to the hills?.

It's that time of year when most companies with a vested interest in stockmarkets punt out their predictions for 2011. From what I've seen so far, the consensus for the UK stockmarket seems to be more positive than negative, on the basis shares look reasonable value (especially versus other types of investment) and companies are running efficiently having shed excess fat (hence rising private sector unemployment in 2009).

I'm not wholly convinced that the outlook is rosy, in fact I've been surprised by the recent surge in share prices given the problems our economy is facing. So I thought I'd start by trying to work out how cheap or expensive shares look right now.

While rudimentary, a company's price to earnings (P/E) ratio is a good measure when comparing the relative price of its shares both over time and to other companies. It shows how many times greater the share price is than annual earnings per share, i.e. if a company's share price is 100p and its earnings are £10,000 with 100,000 shares issued, its P/E would be 10 (1 / 10,000/100,000).

So let's compare current average P/E ratios for the main UK stockmarket (FTSE) sectors with those at the beginning of 2007, before the credit crunch hit.

Sector	Includes	P/E Ratio 3 Jan 2007	Current P/E Ratio	Current Dividend Yield
Basic Materials	mining & chemicals	10.2	11.7	1.2%
Consumer Goods	car makers, drink/food producers & tobacco	14.7	15.0	3.3%
Financials	banks & insurers	13.9	19.2	2.8%
Industrials	construction, engineering & defence	20.7	19.2	2.5%
Oil & Gas	oil/gas producers	10.4	8.8	2.8%
Technology	software & hardware	24.2	23.0	1.2
Telecommunications	fixed line & mobile	22.7	8.4	4.8%
Utilities	electricity, gas & water	18.3	10.2	5.3%
Source: FT (FTSE Actuaries Share Indices UK Series). Current figures as at 14 December 2010.

Some sectors, including consumer services, telecommunications and utilities are noticeably cheaper, while financials are more expensive. But there's not a great difference in the remaining sectors, suggesting a number of companies are valued more or less the same as they were pre-crash.

Now you have to take these figures with a pinch of salt. The earnings used in the above P/E ratios are as reported over the previous year, whereas markets price shares based on expected future earnings. So if you believe earnings will rise then forward looking P/E ratios would be lower than those shown, suggesting there might be some value. But if you think companies will generally struggle to grow earnings then in broad terms the UK stockmarket hardly looks a compelling buy based on P/E ratios.

Another measure of value is dividend yield, i.e. dividends divided by share price. A high yield means high dividends relative to the share price, suggesting the shares might be good value provided the company is sound overall (and remember, dividends are always shown net of basic rate tax). In this low interest rate climate a decent dividend yield holds additional appeal, particularly in sectors that tend not to be excessively volatile - like utilities.

So if you can earn more from dividends (after tax) than cash or gilts and believe the share price will be fairly steady, then maybe certain companies/stockmarket sectors still hold some appeal. But if you're pessimistic about stockmarket prospects then even the lure of attractive dividends is probably not enough to compensate for the risk of losses.

As the for the outlook, I think my views are largely unchanged compared to a year ago - not very optimistic. The economic backdrop is gloomy, with the impact of tax rises and spending cuts yet to bite in earnest, and although companies are generally leaner I don't hold out much hope for meaningful growth over the next year. If you want to invest in UK stockmarkets I'd be inclined to steer towards large, dull, well established companies that pay handsome dividends and tend to be more resilient in a downturn - for example, utility, tobacco and healthcare companies.

Of course, we shouldn't neglect the global nature of the UK stockmarket, around two thirds of earnings come from overseas. But with most Western economies seemingly in a mess I don't think globalisation will be our saviour over the next year or two.

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