The FTSE 100’s valuation is one of the most important factors influencing large-cap investor returns.
Currently, the FTSE 100 has a CAPE (cyclically adjusted PE, or price to inflation-adjusted 10-year average earnings ratio) of 13.3, with the index at 6,750. Relative to historic valuations, that’s what I would call ‘slightly cheap’, which is where the market has been for most of the past four years.
You can see where we are relative to historic valuations in the chart below.
The green river running from lower left to upper right shows how various multiples of cyclically adjusted earnings have grown very consistently over the years as the underlying earnings have grown.
The dark green band in the middle shows the ‘normal’ range of values for the FTSE 100 between a CAPE of 14 and 20. Perhaps this should more accurately be called the ‘middle’ valuation range as the index hasn’t spent all that much time in the ‘normal’ band.
As you can see, we’re just below the ‘normal’ dark green central band, in what I call the ‘slightly cheap’ band.
Going forward from today, there is slightly more upside potential than downside if we assume that the market will revert back to the long-run average CAPE valuation of 16 within the next seven years. You can see that expressed more quantitatively in the following table.
Here I’m assuming that corporate earnings grow at a fairly typical rate of 4% a year and that the market returns to a CAPE of 16 in 7 years.
If that were the case, then the FTSE 100 would be at 10,696 in 2021, and we would have received a total return of around 87%, including dividends, or just over 9% annualised.
That’s a slightly higher rate of return than you would normally expect from the UK markets (typically inflation plus 5%), which is largely because the starting valuation today is slightly cheaper than usual. That lower starting point creates higher future returns because of higher dividend yields and additional capital gains as the market is re-rated upwards very slightly.
On that basis, even though we’re near record highs, the FTSE 100 appears to be a reasonable place for a long-term investment.
The Ben Graham equity allocation in the table above is a simple active asset allocation tool that is based on an idea from Ben Graham. The idea was that an investor might want to move out of equities as valuations rise and get more heavily into them as valuations fall, within a range of perhaps 25% in equities all the way up to 75% (although personally, I’m always 100% in equities).