Could the FTSE 100 fall to 2,500 points?

When Morgan Stanley (AMEX:MWD) published its 2009 outlook for the UK market in December, it gave a 35 per cent probability to such an outcome. The bank’s bear case scenario assumed that problems in the global economy became so severe that the authorities were limited in their ability to stabilise the situation.

“We would likely see renewed stresses in financial money markets, further recapitalisations of the banking sector, possible currency issues and an insipid response to any fiscal boost,” said strategist Graham Secker at the time.

As anyone who has followed the markets in recent weeks knows, many of those things are happening. Banks are still being bailed out and the various stimulus packages that have been introduced by central banks and governments to combat the credit crunch are yet to have an effect. Things aren’t out of control, but the economic and corporate data keep getting worse.

Indeed, profit warnings, earnings downgrades, job losses, grim economic data and rights issues are all commonplace.

On Friday, for example, fourth-quarter US gross domestic product was revised down to show a 6.2 per cent contraction, while the US Treasury said it would be taking a 36 per cent stake in Citigroup in another attempt to boost its depleted capital base. Data earlier in the week showed US consumer confidence hit a record low in February, while house prices in big US cities plunged at the end of last year.

Closer to home, the UK government announced plans to inject a further £25.5bn in Royal Bank of Scotland, while rumours swirled of a huge rights issue from HSBC. Analysts said even BP might be forced to cut its dividend.

There are, of course, many reasons for thinking the FTSE 100 will fall nowhere near 2,500. One is valuation. Stocks are cheap and a lot of the bad news is already priced in.

Citigroup, for example, thinks current market levels reflect expectations of a near-halving of corporate earnings. The MSCI UK index currently trades on a trailing price/earnings ratio of 6.3, its lowest level since 1981; a price to book value of 1.2, which is a 14-year low; and a dividend yield of 5.8 per cent, the highest since 1980.

It is also worth remembering that the consensus call at the start of the year was for the FTSE 100 to revisit its November low during the first half of 2009 (it is currently 50 points above that low) and then push higher in the second half as the global economy responds to the fiscal medicine. While there are no green shoots of recovery at the moment, who is to say they won’t appear by the autumn?

But just because stocks are cheap does not mean they cannot fall further. Markets always overshoot on the way up and down.

Take one of the most widely respected valuation measures – the cyclical price/ earnings ratio. This compares share prices with average earnings during the past decade, rather than the most recent year’s earnings. It is widely followed because it evens out bumps in earnings multiples caused by the profit cycle.

The UK is currently trading on a cyclical price/earnings ratio of 12, which is around its historic average. But in previous bear markets this ratio has had to reach 6-8 before the stock market has bottomed.

For equities to make any progress in the second half of the year, a number of things have to happen, Mr Secker says. First, corporate earnings have to trough. Second, US house prices have to stabilise. Third, further progress needs to be made with de-leveraging (companies paying down debts and banks shrinking their balance sheets). Unfortunately, he does not see any of those things happening until the middle of next year.

But neither does he think the FTSE 100 will hit 2,500. “We don’t necessarily think it will get that low. However, there is further downside if newsflow continues to be poor.”

And the data are poor. Add persistent deflation fears and it is difficult to see the FTSE 100 making any progress. That is not to say it will be dull. Markets are likely to swing violently, as they have done for many months.

neil.hume@ft.com