Is the recent FTSE 100 rally built on sand?

Updated: 
City and falling FTSE 100 share prices

It's been a great year to be an investor in the UK's leading stock index. After a rocky 2015, which saw the FTSE 100 jump to a high of 7,089 before crashing back under 6,000, this year the index has risen from a low of 5,700 to a high of nearly 7,050,ba gain of around 13%. 

These gains have come despite Brexit and Trump, confounding almost all of the City's top equity analysts. Most analysts were forecasting a broad-based sell-off following a Brexit or Trump event.  

The big question is why do investors feel so optimistic when the outlook for the global economy has never been more uncertain?

Dissecting the gains

A good chunk of the FTSE 100's gains since the end of June have come thanks to the devaluation of sterling. More than two-thirds of the index's earnings come from outside the UK and a weaker pound translates into higher earnings for the index's constituents. Greater earnings potential has made the index look cheaper, and as a result, investors have been buying. 

However, in US dollar terms, excluding the lift from weak sterling, the FTSE 100 has actually fallen by 4% this year. 

So stripping out currency effects, the FTSE 100's recent rally is non-existent. But it's not just weak sterling that's given the UK's leading index a boost this year. Donald Trump's election as president of the United States has lifted US equity markets, sending the S&P 500 and Dow Jones Industrial Average to record levels on the hopes the he will unleash a multi-trillion dollar stimulus programme to make America great again. 

In my view, this Trump-driven rally is going to be short-lived. Investors are buying into his dream but for how much longer this will last remains to be seen. Trump has promised a lot, and it's highly likely he will fail to deliver on all of his promises. Markets like to buy the rumor and sell the news, so even if Trump does deliver the US markets could slump, which would drag the FTSE 100 down with them. 

Built on sand

The FTSE 100's recent gains are nothing more than Trump hope and a weak pound. If sterling recovers its losses next year, the index's gains could evaporate, and if Trump fails as America's saviour, the FTSE 100 will surely come off its highs. 

Still, if the FTSE 100's constituents manage to generate material earnings growth next year, the index may be able to hold on to its gains. If the pound remains depressed, it will also be good news for the index. 

Look to the long term

Having said all of the above, long-term investors don't need to be worried about what the next 12 months hold for the FTSE 100. Currency fluctuations and political turbulence are a natural part of investing in the short term but over the next five or 10 years, turmoil in the next 12 months won't matter to investment returns. 

Overall, the FTSE 100's 2016 rally might be built on sand, but over the long-term, the index is bound to generate steady returns for investors.

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.