Why The FTSE 100 Is In Danger Of A Horrible Correction!

Royston Wild explains why the FTSE 100 (INDEXFTSE: UKX) remains in severe peril.

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Another week, another baffling rise for the FTSE 100 (INDEXFTSE: UKX).

Britain’s foremost index stepped above the 6,400-point landmark for the first time since early December on Tuesday, taking total gains in the past three months to 13%.

Despite the FTSE 100’s resilience, however, I remain convinced that a severe retracement remains very much in the offing.

Built on creaking commodities

One of my major concerns over the fate the FTSE 100 is that index is being kept afloat mostly by a resurgence in commodities-related stocks. Indeed, nine of the Footsie’s top ten risers during the past three months are involved metals or fossil fuels excavation.

Diversified producer Anglo American — a company heavily upon the worsening iron ore market — has led the chargers, the stock gaining an unfathomable 257% since hitting multi-year troughs in January!

Fellow diversified diggers Glencore, BHP Billiton and Rio Tinto have also torn higher during the past few months. And dedicated oil play Shell has also performed exceptionally, its share price rising 42% during the period, while gold excavator Randgold Resources‘ share value has advanced almost 50%.

Overvalued

I reckon Randgold Resources’ rise may hold up better than its peers in the near-term, however, the prospect of further macroeconomic bumpiness possibly prompting further ‘safe haven’ buying into precious metals.

But the worsening supply/imbalances washing across most major commodities markets is leaving much of the resources sector on shaky ground, in my opinion. Each of the commodities plays described above is now sailing well above a P/E rating of 10 times, territory reserved for stocks with high risk profiles. This leaves plenty of room for a stark correction.

And a huge reversal is a very real possibility should Chinese economic data continue to disappoint, and the US dollar regains strength thanks to fresh Federal Reserve monetary tightening and weakening emerging market currencies.

Developing regions on the rack?

Indeed, wider concerns over the health of developing markets provides another lever for a harsh retracement. Data this month showed China’s economy expand just 1.1% between January-March and the previous quarter, casting fresh doubts over Beijing’s 2016 growth target of between 6.5% and 7%.

Stocks with a huge emerging market bias like Standard Chartered, Unilever and British American Tobacco have also punched huge gains in the past three months, these stocks rising 18%, 17% and 19%, respectively, since mid-January.

So while I believe many such companies remain strong long-term buys, signs of fresh economic choppiness in far-flung regions could send these shares — and with them the broader FTSE 100 — sinking again.

Think of England

And of course there are plenty of worries closer to home that could send the FTSE 100 shuttling lower.

The run-up to June’s EU referendum is likely to prompt plenty of volatility across share markets, particularly if polling data suggests that voters are leaning towards a possible ‘Brexit.’ And an eventual ‘leave’ vote could send investors packing as Footsie companies large and small tackle a range of issues, from escalating labour costs to the financial impact of future trade deals.

Meanwhile, concerns that the British economy is losing steam are also gaining momentum. Data on Wednesday showed UK unemployment increase for the first time since mid-2015, a 21,000 rise taking total jobless to 1.7m. And earnings growth slowed to 1.8% from 2.1% in the prior three months.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Royston Wild has no position in any shares mentioned. The Motley Fool UK owns shares of Unilever and has recommended Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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