The performance of equities this year has been driven by the switch into so-called cyclical stocks - companies that benefit from economic growth. The FTSE 100 hit its year high of 6,620.6 in July, a rise of 13 per cent since 1 January. At the same time, the All-Share hit a high of 3,166.9, up 18 per cent on the year. Cyclicals dominate the FTSE 250, hence the stronger performance of the All-Share against the FTSE 100.
The Asian and Russian economic crises meant cyclical stocks were at rock-bottom prices last year. Central banks responded by slashing interest rates to kick-start global recovery. The stage was set for an investor spending spree on cyclicals.
The expected economic recovery has taken place and the year's strongest- performing sectors are almost all cyclical. Mining leads, followed, in rank order, by packaging, chemicals, distribution, automobiles, oil and gas, real estate, electronics and electrical equipment, media and telecoms. The economic growth has also translated into higher bond yields.
Ian Scott, European equity strategist at Lehman Brothers, sees parallels with the flight into cyclicals following Britain's exit from the European Exchange Rate Mechanism in 1993. Unlike then, however, sterling is strong and this has deterred investors from buying into domestic cyclical stocks. "This time the international aspect is important. It's global stocks, like oil and mining companies, that have performed well," he says.
This year's 105 per cent rise of Billiton, 89 per cent rise of Anglo American and 51 per cent rise of Rio Tinto - all mining stocks - illustrates the popularity of cyclical stocks. The rise in bond yields has meanwhile put pressure on financial stocks, with Abbey National down 22 per cent, Halifax down 18 per cent, and Lloyds TSB and Alliance & Leicester both down 12 per cent.
The worry, however, is that the pace of economic growth, especially in the US, is too strong, making further rises in both interest rates and bond yields likely. This would have a knock-on effect for the FTSE 100 and All-Share, whose recent swings can be charted in response to the publication of US economic data, good and bad.
"What's happened in the last week is that the market has gone from believing the Federal Reserve is totally in control of the US economy to believing it is controlling the economy quite well. Of course, that's still pretty good. It's just that it can knock 10 per cent off equity prices," says Robert Buckland, UK equity strategist at Salomon Smith Barney. "The market needs to see signs the US economy is slowing. That's not happening. The market is focusing on the impact of future rate rises, so housebuilders are being sold off, despite good profits."
The upward trend in bond yields, around 6 per cent, seems set to continue as GDP growth continues across the globe. "We could be seeing the most synchronised global economic expansion since 1945 and it's these growth prospects that are scaring markets," says Mike Young, European equity strategist at Goldman Sachs. "That could put the squeeze on capacity, fuelling inflationary concerns."
This does not bode well for the FTSE 100, Mr Young says. "This is not ideal for the UK market. The FTSE doesn't have stocks that benefit from that economic scenario. It's dominated by financials, utilities, food retailing and pharmaceuticals."
Although the oil majors should typically benefit from economic growth, Mr Young sees them as vulnerable to a sell-off as oil explorers become more attractive given the recovery of the oil price. The most vulnerable FTSE stocks, however, are telecoms companies such as Vodafone Airtouch, up 38 per cent this year, and Orange, up 56 per cent. "This economic environment does not benefit growth stocks. FTSE 250 [stocks] are better exposed, but they are taking a hit from sterling."
Mr Young continues to see value in sticking to cyclicals, which should help drive the FTSE to 6,600 within 12 months. WPP, the media group, up 55 per cent this year, and British Steel, up 72 per cent, are favourites.
Philip Wolstencroft, equity strategist at Merrill Lynch, agrees. Equities will continue their downward trajectory, pulled down by growth stocks in sectors such as telecoms and IT. "The reason the market is going down is because the economy is strong, and the world economy shows no sign of decline."
Other strategists disagree. Ian Scott has been recommending a switch out of cyclical stocks since June. "Perhaps that was a bit early. But in the last month cyclicals like packaging, construction, steel, retailing and engineering have been the worst performers."
He argues for a switch into defensive stocks such as pharmaceuticals, and also sees value in domestic cyclical stocks such as retailers, brewers and hoteliers, which have suffered in recent weeks from profit-taking in response to higher UK interest rates. He tips stocks such as AstraZeneca, SmithKline Beecham, Reckitt & Colman, Hilton, Unilever and Carlton.
Robert Buckland is less worried, however, seeing the FTSE 100 hitting 6,800 by mid-2000. "People aren't saying the Fed has lost it. They're just worrying a bit more. At these levels, I'd advise investors to dip a toe in the market."Reuse content