The FTSE 100 hit a new record high of 7,698.5 on Thursday morning, beating the peak of 7,696.8 seen on 29 December.
What does this mean for investors? Should we be taking profits, or throwing fresh cash at the market? Personally, I’m not sure either of these approaches is the right one.
Are earnings rising?
The first question to ask is whether the index as a whole is expensive. Understanding valuation requires us to look at earnings as well as price. If the earnings of the companies in the index are rising, then the FTSE may remain affordable.
The latest index figures show us that the companies in the FTSE 100 collectively trade on a P/E of 22, with a dividend yield of 3.8%. Of course, that’s just a snapshot.
An alternative way of valuing stocks for long-term investors is to compare price with 10-year average earnings. On this measure (known as CAPE or PE10), the FTSE 100 currently trades on around 17 times long-term average earnings.
In my view, this valuation suggests that the index is fully valued at the moment, but not overly expensive. From what I can see, it is equally likely to rise or fall this year.
As stock investors, we need to find an edge. I believe this lies in careful stock picking.
How I’ve prepared for 2018
As a value and income investor, I’m always on the lookout for good quality stocks that are going cheap. I’ve tightened my focus on value and quality for 2018, in the hope that this will leave me in a win-win situation.
If there’s a market correction, I hope that good, cheap stocks will be most resilient and will bounce back quickly.
If markets continue to climb, then I hope that my focus on quality and value will be rewarded by strong gains from the stocks I own.
What I’m selling
One type of stock I’m steering away from are so-called ‘expensive defensives’. Companies such as Unilever, Diageo, Reckitt Benckiser and British American Tobacco. These highly profitable firms are generally viewed as defensive businesses, where customer spending remains strong even during recessions.
The only problem is that years of low bond yields have driven investors into these stocks in search of income. Most of these stocks now trade on fairly steep valuations, with below-average dividend yields. I don’t see this as an attractive starting point for an investment.
I sold my shares of Diageo and Unilever last year. While I view these as attractive businesses, I don’t plan to reinvest until the shares become more affordable. I accept that I may miss out on some profits, but I think the downside risks outweigh the potential for gains.
What I’m buying
In my view, the FTSE 100 continues to offer value in sectors that have been out of favour in recent years.
Potential examples include insurance and banking stocks, some retailers, big utilities, plus mining and oil stocks.
Stocks for which I have high hopes in 2018 include Centrica and Standard Chartered. I also see potential in housebuilders, although I’m wary about investing after such a long bull market.
Whatever you choose, I’d encourage you to focus on maintaining a diverse portfolio and only investing money you won’t need for at least three to five years.
Roland Head owns shares of Centrica and Standard Chartered. The Motley Fool UK owns shares of and has recommended Unilever. The Motley Fool UK has recommended Diageo and Reckitt Benckiser. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.