The rise in the FTSE 100 vs. the real world

At this time of the year commentators like to express their views as to the coming year. Much of this seems to based on extrapolating the recent rise in the FTSE 100 (UKX) and concluding that the recession is coming to an end.

Of course, differing views are required to make a market - and my view is that the rise in the FTSE 100 merely shows how detached the share price formation process is from the real world.

Here are my key reasons:

a) Unemployment

The feedback from students and graduates confirms that finding work (part time or full time) is much more difficult than it has been recently. For example, I was talking recently to the owner of a business which includes a graduate intake as part of its employment strategy. In 2009, incoming graduates were paid at the rate of £14,500 p.a., but in 2010 this rate has fallen by c.66%.

Another factor which is going to impact adversely on those seeking jobs is the effect of government expenditure cutbacks, which both reduces the jobs available (within the public sector and also in private sector companies serving the public sector) and increases the pool of people seeking work.

In my opinion, the above is going to result in people having to price themselves back in to work (i.e. there will be some wage deflation).

b) Inflation or Deflation?

There is much talk about inflation and interest rates having to rise in order to deal with it. In my view, a distinction has to be made between wage inflation and increases in the cost of goods and services. For the reasons given above, I think that the risk of wage inflation is minimal. The antidote to price increases in goods and services is that we (with few exceptions) have it within our control to consume less of the good or service which has risen in price (i.e. if the price of coffee rises excessively, we drink less of it) - this reaction will increase in a world of wage deflation. Perhaps fewer people will feel able to escape the UK for some sunshine at Christmas or consume ready meals in preference to preparing their own food!

c) Discretionary Expenditure

The result of a) and b) is that, on average, individuals' income available for discretionary expenditure is going to fall - this will be further compounded by the need to save more towards old age as the realisation dawns that many pension schemes will not deliver in line with previous expectations.

From the standpoint of many individuals, I don't think that the above scenario need be too gloomy. This is because the manufacturing cost of many goods is relatively modest compared with the price at which they can be bought from retailers (that is, various intermediaries presently command significant mark-ups on the manufacturing cost, even though they deliver relatively modest added value from the standpoint of the end consumer). In my opinion, a core theme of the coming decade is going to be an acceleration in disintermediation - shortening the chain between supplier and consumer. Much of this will be achieved through the increased use of the internet and other technologies to make markets more efficient.

From an investment standpoint, I believe that there will be significant returns to be achieved from investing in companies which facilitate disintermediation (continuing LCF Research's core theme of seeking companies which improve the productivity of customers), but I find it difficult to envisage FTSE 100 companies collectively benefiting from this trend.

We at LCF Research wish you a rewarding 2011.