David Kuo: Stock market should rise above high-street gloom

Investment Insider

There is no reason why anyone should have been shocked by news that the UK economy shrank in the last quarter of 2010.

A quick peek out of our windows in December would have told us that the unusually harsh weather had curbed festive spending. Given that economic growth is heavily dependent on consumer spending, the dearth of shoppers was bound to have an adverse effect.

Despite the disappointing quarterly figures, the economy still managed to grow 1.7 per cent in 2010. The IMF reckons growth could be about 2 per cent this year, which is not too shabby. That said, economic growth here will be overshadowed by growth in India and China of 8.4 per cent and 9.6 per cent respectively.

However, growth in India and China is pushing up prices and these are gradually finding their way into our shopping baskets. It is little wonder that inflation, as measured by the Consumer Prices Index, has climbed to 3.7 per cent. The Retail Prices Index, which is a better reflection of our personal inflation, is a worrying 4.7 per cent.

The Bank of England maintains that we have nothing to fret about because the rate of inflation should fall back next year. However, the pace of price increases could rise further in the coming months. How many British workers will be relaxed about inflation when they are offered sub-inflation pay rises?

Curiously, the stock market could produce some good returns. For the 2010 financial year, company profits could rise to £150bn. This helped the FTSE 100 index to climb from 5412 points in January to 5899 points in December, having briefly crossed the 6000 mark before Christmas.

Company profits are forecast to continue to recover in 2011. Current analyst estimates point to collective profits of £186bn for FTSE 100 companies. But the market is still not rating profits highly. At present, FTSE 100 companies are worth about £2trn, which implies a valuation of just 13.2 times profits for 2010.

A re-rating of between 12 and 14 times profit for 2011 could see the value of FTSE 100 companies increase to between £2.2trn and £2.6trn. Of course, there are no guarantees that the market will assign a higher rating to shares. But if it does, then even a modest re-rating coupled with stronger company profits could push the FTSE to an all-time high.

David Kuo is director of financial website fool.co.uk