How the FTSE 100 could surge to 7,000 this year

One theory doing the rounds is that the stock market could rally after the UK referendum on EU membership. Markets hate uncertainty so whether we vote in or out the immediate outcome for investors could be positive, or so the argument goes.

If that happens, it’s easy to imagine the FTSE 100 rallying as far as 7,000 by the end of the year. After all, it was at that level just one year ago.

Is the downside already priced-in?

That theory might sound wacky because intuitively the whole referendum business feels like a threat to shares. It’s easy to imagine an out vote causing a bear market because of the uncertainty that would imply. However, the market knows about the referendum, which suggests it might already have allowed for the downside scenario.

Some studies suggest that if Britain left the EU the economic outcome could be neutral for the UK. If that’s correct, I see no reason for the stock market to fall too far, and certainly no reason for it to stay down because of the referendum. The more I think about it, the more attractive the theory of a relief rally becomes to me.

Is a FTSE 100 tracker fund the best vehicle?

A basic FTSE 100 tracker fund will replicate the constituents of the index by weighting. The trouble is that about 70% of the money we invest in a FTSE 100 tracker goes into just 30 companies. Apart from that unwanted skew to the fortunes of the biggest firms in the index, another outcome is that around 50% of a FTSE 100 investment ends up in cyclical firms.

Perhaps that’s a good thing if we believe cyclicals such as commodity firms, banks and oil companies can be the drivers of a FTSE 100 rally this year. After all, such sectors have fallen a long way over the last two years or so and could be due a comeback. But the fear is that dividend yields look too high in many cases, which strikes me as a more of a warning than a reason to buy.

For example, HSBC Holdings‘ forward yield for 2016 runs at just over 8% and BP‘s is just below 7%. Unsustainable? Maybe. Other cyclical firms have been cutting their payouts this year, such as BHP Billiton and Barclays.

Cyclicals are hard to judge

A dividend cut can be a good thing with cyclical firms as it often indicates earnings are low, thus suggesting a cyclical firm’s business may be closer to the bottom of its trading cycle than it is to the top. However, I’m still wary of revisiting cyclicals because it’s harder to judge the timing of an investment in them than it is in firms operating in less cyclical sectors. I don’t see a screaming signal that world economies are near to the bottom of their cycles — far from it — and the time to go for cyclical investments is when things are at their worst, in the hope of catching the next cyclical up-leg. Right now, things could go either way for cyclicals as we inhabit the strange ‘no man’s land’ of relatively benign economic conditions.

To play the potential for a post-referendum relief rally, there’s better value to be found in the smaller 70 or so firms occupying the FTSE 100 that would only attract around 30% of my capital if I were to invest in a FTSE 100 tracker fund.

To me, the best solution is individual share picking, such as these five firms, which make good candidates for further research and remain strong and well placed in their industries.

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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has recommended Barclays, BP, and HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.