A dismal start to the new year has borne out our earlier caution about the outlook for the stock market, though the picture should brighten later in the year. The FTSE 100 Share Index has been hovering above and below 6,200 points, eight per cent below its 52-week high, and the AIM index has recently been trading 16 per cent off its year’s peak, as the continuing problems of the finance sector and concern about corporate profit downgrades combine with recessionary vibrations from across the Atlantic to depress sentiment.

True, the next move in UK interest rates is likely to be another cut, after the Bank of England’s Monetary Policy Committee’s latest decision to hold, and bargain hunting could bring out some bolder spirits. From Washington, the Federal Reserve looks set on further cuts to help revive the US economy, while sterling’s weakness against the euro could provide some easing for exporters – even if it does reflect the UK economy’s fall to sixth place in the world, below France, for the first time since 1999.

The inflation clouds are gathering. The cost of money is, of course, a powerful determinant of market movements, but the parlous state of Britain’s public finances, rising food and fuel prices and public sector union pressure for wage rises at least double the inflation rate now cloud the picture. Together, they suggest old-style stagflation could be staging a comeback, which would limit the authorities’ scope for repeated stimulatory measures.

Special situations, consolidation moves and bids are likely to offer the most opportunities in the near term, until the true state of banks’ finances becomes clearer and the economic outlook is easier to assess. The moment to wait for is when every market sage, player and guru agrees that the end of the world is nigh. Such a consensus usually signals a market upturn. But it has not, as yet, been reached.

Gold hot, retailers not
Gold’s relentless rise, at one point going through US$900 an ounce for the first time, has provided a fair measure of the lack of confidence in how governments and other institutions are coping with current challenges. Adjusted for inflation and currency changes, however, its real price in sterling has performed far from remarkably since previous peaks in the 1980s.

Such considerations have not prevented gold shares, such as Anglogold Ashanti, Centamin Egypt, Randgold Resources and Highland Gold from testing new 12-month highs, while, among the big mining companies, the game
is to guess which will become the next bid target, in the wake of world leader BHP Billiton’s bid for Rio Tinto. In oil and gas, the major players, such as Chevron and ExxonMobil, are seen to have the clout to benefit from oil’s recent strength, though others, such as China methane play Green Dragon Gas, have also won fans.

The retail sector has provided some of the most dramatic market action. After what was generally assumed to have been a lacklustre Christmas, the newly knighted Marks and Spencer chief executive, Sir Stuart Rose, dismayed followers by revealing a 2.2 per cent fall in like-for-like sales in the October-to-December quarter.

This prompted a sector sell-off, leaving Marks shares, which were nearly 750p last May, down at 413p, as the magic of the Rose-led restoration of the shopping giant faded in the face of consumer caution. Rose’s description of ‘the toughest trading conditions I have seen in a decade’ sent a chill through the whole sector.

Even J Sainsbury, which reported a 3.7 per cent like-for-like sales increase in the Christmas quarter, is at 384p, more than 200p down from its July level. Tesco is weathering the storm somewhat better, only 69p off its November 52-week high.
Further up the chain, leading grocery supplier Premier Foods at 148p is, despite recent rallies, 55 per cent off since a year ago. The company has insisted it is coping with increased wheat prices and drawing benefits from a major internal reorganisation, but market expectations of a rights issue hit the price, while Northern Foods has also touched 12-month lows.

Financials in need of help
Attention in the finance sector has continued to focus on its woes, diverted only by ex-prime minister Tony Blair’s landing of a lucrative consultancy role with US giant JPMorgan. Interest rate cuts could bring relief to some of the players here, provided their results show their problems to be beatable.

Only the boldest punters have, as yet, sought to buy on recovery. That requires strong nerves and determination and can be risky, as SRM and RAB Capital showed by taking significant positions in stricken Northern Rock.

Shares of most of the big banks are well down on last year’s highs, with Lloyds TSB at 428p and HBOS at 663p among those recently to have tested new 12-month lows. Alliance & Leicester has rallied nearly 180p to 752p, though still a long way down from nearly £12.59 in April 2006.

Buy-to-let mortgage provider Paragon lives to fight another day, after a £287 million rescue rights issue underwritten by UBS at 10p, a discount of no less than 90 per cent to its previous price. Its shares, which topped 760p nearly two years ago, have rallied 10p to 71.5p on the prospect of some eventual light at the end of the tunnel.
Elsewhere, embattled life insurer Friends Provident, which ousted its chief executive in November and faces a £400 million cash shortfall over the next few years, was prompted to consider selling its 53 per cent holding in investment management group F&C Management, worth a possible £509 million.

Away from these woes, diversified brewer Scottish & Newcastle, now 737p, has been holding out against talks with potential bidders Carlsberg and Heineken until at least 800p a share is on the table. Defence giant BAE Systems, 495p, has won a US Government order for bomb disposal vehicles, potentially worth £1.2 billion.

Robert Tyerman is news editor of Growth Company Investor, the UK’s leading magazine for AIM and small-cap analysis.