The FTSE 100 has had another good year so far, up more than 15%, including dividends. From the lows of March 2009, its total returns have been more than 100%, and some investors have started to get nervous.
The “wall of worry” is as good a description as any; the higher the market goes, the more investors worry; but are they right to worry?
Let’s have a look at a chart of the FTSE 100, courtesy of Google Finance:
Here we can see that over the past 30 years, the FTSE 100 can be split into two halves – The happy days of the 80s and 90s, when the market went up with very little volatility (except the market crash in 1987), and the much less happy, sideways bouncing years that we’ve had since 1999/2000.
From this chart, it seems that there is an invisible barrier at 7,000. Is this some natural limit that the stock market simply cannot pass?
The index’s price level is only half the story
The problem with looking at the market in this way is that all we can see is the price. It’s like me asking you if you want to buy a car for £10,000, but not telling you what car you’d be buying.
If it’s a brand new Rolls Royce Phantom, then you’re getting a good deal, but if it’s a 1988 Ford Sierra, then perhaps the deal is not so good.
We need to see some information about what exactly we’re buying when we buy the FTSE 100. Of course, what we’re buying is a group of 100 companies, but we don’t even particularly want the companies. What we want is a piece of their profits and their dividends.
Along with the price of the FTSE 100 (its index level) we also need to look at its earnings, and specifically its smoothed earnings. Smoothed earnings remove most of the effects of the business cycle, whose short-term ups and downs just confuse matters.
These smoothed earnings are most commonly measured using CAPE (Cyclically Adjusted PE), which is the ratio of the price to the average inflation-adjusted earnings of the past decade.
The chart below overlays the price of the FTSE 100 with a range of CAPE values so that we can see where the market is, in terms of how expensive or cheap it is, relative to the kind of CAPE values it has had in the past.
During the past 25 years, the market’s valuation has swung from more than 30 times its cyclically adjusted earnings at the peak of the dot-com bubble in 1999, down to less than 12 times its cyclically adjusted earnings in the lows of 2009.
Today the FTSE 100’s price is close to where it was in the dot-com bubble. However, since then, the cyclically adjusted earnings of the FTSE 100 companies have increased smoothly over time, and that’s what we should expect them to do because of inflation and long-term economic growth. And, as the cyclically adjusted earnings grow, so do the valuation bands.
So even though we are close to an all-time record price, we are not even close to record valuations because the value of the index (as measured by its earnings) has gone up considerably.
Because of the growth of earnings over the years, the FTSE 100 now has a CAPE of around 14, which is at the lower edge of the central band of CAPE values which runs from 14 to 18, and which I call the “normal” valuation band.
Don’t panic – The market is not expensive
So what does this all mean? It means that even though the FTSE 100 is close to its all-time highs, it is still relatively cheap compared to the valuation multiple that investors have been willing to pay in the past.
It means that even if we break through the 7,000 barrier, it still won’t be expensive. In fact, the FTSE 100 would need to be almost 9,000 before I would even begin to call it expensive.
Of course, the market could still fall (and probably will), but at these relatively low valuations, for long-term investors, I think that would be an opportunity and not a risk.