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LONDON -- The FTSE 100 (FTSEINDICES: ^FTSE ) is set to surge by 8% in 2013 -- at least, that's the prediction of one investment manager, Legal and General Investment Management. No doubt there will be many more premonitions by the end of the month.
Perhaps unfortunately, LGIM's prediction was released on the same day that Margate was tipped as one of the top 10 places in the world to visit in 2013. That possibly says something about how much reliance can be placed on forecasts.
But there are good arguments to underpin LGIM's bullish outlook. It points to how cheap shares look compared to government bonds, yielding approximately twice as much. And it sees modest growth in corporate profits -- not from the U.K. economy, which it expects to remain sluggish, but from overseas markets such as the BRICs. It therefore expects investors to shift allocations into equities for their better yield and earnings prospects.
It's a "top-down" forecast based on economics, and whatever the actual numbers, it's a plausible argument that the FTSE 100 will enjoy another year of good growth. Barring the U.S. falling off a fiscal cliff, a meltdown in the eurozone, or some other Black Swan/Grey Swan/end-of-the-Mayan-calendar cataclysm, I'm inclined to believe it.
But one of the remarkable things about the FTSE 100 is just how concentrated it is. Just three sectors -- oil and gas, financials, and mining -- make up half the index. And the top four shares -- HSBC (LSE: HSBA ) , BP (LSE: BP ) , the two classes of Royal Dutch Shell (LSE: RDSB ) shares, and Vodafone (LSE: VOD ) -- make up more than a quarter.
So the prospects for those four companies and three sectors will have pretty good control of the index's direction. It's a "bottom-up" way of looking at the FTSE 100.
With its sprawling international operations, HSBC is something of a proxy for the global economy, skewed toward the developing markets of Asia and Latin America. That should give it long-term, slow-burn growth, while its diversity cushions downside risk. The bank was relatively resilient in the financial crisis, and it's a good long-term hold.
The rest of the banking sector -- especially Lloyds, RBS, and Barclays -- are more geared to the U.K., Europe, and the U.S. There's a good chance they'll enjoy a strong year. The two state-owned banks in particular have made progress in clearing out their balance sheets and turning around their performance. However, all of them are vulnerable to a eurozone blow-up.
Shell is a strong, diversified play on the sector, but its big investment in U.S. shale gas, where the exploration glut has depressed prices, will weigh on its performance. Still, on a price-to-earnings ratio of less than nine, it's a great share to hold.
BP is far the more adventurous -- and risky -- share. With litigation in the U.S. hopefully out the way in early 2013, its shares should gradually be rerated by the market as its new big Russian play starts to deliver to the bottom line.
Vodafone is the most defensive of these four stocks. Though its Southern European operations have suffered this year as cash-strapped Italians, Greeks, and Portuguese have pared back their spending, there is little doubt that mobile phones have become a basic necessity of life. Vodafone is generating a healthy cash flow, and it's hard to argue with a 6% yield.
So defensive stocks are still where most of my money is going. I'm encouraged that Legal and General sees more money going into equities, and generally I'm bullish about the market. We'll know by the weekend whether the end of the Mayan calendar heralds the end of the world (or if it's just another example of bad forecasting), and early 2013 should see some resolution of the U.S. fiscal cliff.
But the eurozone debacle will hang around for the whole of next year, with the potential to wreak havoc on markets. So I am still biased toward stocks that would suffer relatively lightly.
If you want to build your wealth, not losing money is just as important as making it. And many defensive shares have attractive dividend yields much higher than bank interest rates. What's more, reinvesting dividends makes a real difference to how your wealth grows. This special free report from The Motley Fool, "Ten Steps to Making a Million in the Market," tells you how an investment in one particular defensive share, held for 10 years with the dividends reinvested, would have generated an average compound return of 22% per year for 10 years.