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).
Do you compare the valuation with its historical norms or would you also be interested in how the FTSE compares to other developed markets? For example would you go into other developed markets like Germany or the US if their CAPE valuations were more attractive than the FTSE? Or would you only go into such markets if their CAPE values were both more attractive than the FTSE and also cheap compared to their historical averages too?
Assuming of course you hedged out the exchange rate risk or were in so many currencies (as I am) that it evens out anyway in the long run.
Hi Andrew, that’s a great question.
I compare index valuations against their own historic valuation averages. However, I think indices should be comparable against each other too, so I am interested in how the UK indices compare to those for other nations. CAPE is still a pretty murky indicator (but far better than the standard PE), so it’s hard to say which would be best, i.e. comparison against historic averages or against other indices. I think against other indices makes more sense from an efficient market point of view, but in practice some markets have quite different long-term mean valuations over long periods of time (i.e. Japan). So some blend of the two approaches may be useful.
In an ideal world, given enough data, experience and time, I would invest globally, but country CAPE wouldn’t be the primary determinant for whether or not I invested in a particular country. Ideally I would value stocks as I do now, and that would lead me to whatever had the best combination of quality, value, income and growth, no matter where it was in the world. But I would expect a fairly strong correlation between market CAPE and the number of attractive bargains in that market.
Also, Dominic Picarda of the Investors Chronicle has been looking at country CAPE as a way to outperform. I think a CAPE tilted portfolio of various national indices is a no-brainer for someone to run as an ETF.
Interesting to bring up Graham’s concept of shifting into/out of equities as the market moves. If I remember my Intelligent Investor correctly, he was proposing balancing between equities and bonds, and that the tendency is that bonds tend to become cheaper as equity markets become more expensive. From a very simplistic point of view, his approach of slowly shifting equities to bonds would be an approach of selling high (equities) and buying low (bonds). And then as the trend reverses, selling high (bonds) and buying low (equities).
If this theory generally holds true, being 100% in equities means that you are forgoing the chance to invest in bonds when cheap, and possibly over-investing in equities when they’re expensive, or at least missing out on selling equities in general when the whole market is high.
With the footnotes from more recent times, I think his approach for passive investors boiled down to rebalancing between equity and bond indices, hopefully buying low, selling high on each side.
Probably about 10-15% of my investments are in bonds, using the iShares SLXX Corporate bond ETF. I’ve been in it for about 4 years now. It produces a constant, unexciting dividend which is slightly higher than the FTSE 100’s. But, unless you time purchases well, there is no capital growth.
I’ve not been investing a long time. I have the impression that bond markets change levels very slowly, or after very big events. If you assume further global recovery (and improvement for equities), I’m wondering if the medium term prospects for bonds is to slowly become cheaper.
It kind of does so little that I have neither good nor bad feelings about having invested in it. I still have free cash, so it’s not taking up capital I’d otherwise put in equities. And it does produce a little psychological benefit on the days when I look at the market, and everything in the portfolio is red, except for SLXX (as in the last few days with Ukraine troubles).
What are your thoughts on the value of having some investment in bonds, ways to do it, and Graham’s balancing?
Hi Bob
I do own some bond index ETFs, but only an incidental amount in an account I don’t look at much. My portfolio is effectively 100% equities and I expect it to stay that way until I am no longer interested in active investing (at which point I’ll probably switch to 50/50 in a global equity index and a global bond index).
My thoughts on Graham’s rebalancing are laid out in the blog post’s table. Graham mentioned moving between 25% and 75%, and I think that’s reasonable and sensible, rather than going from 0-100%. However, exactly what makes up the non-equity side of the portfolio is another matter.
I don’t really have any hard opinion on it. I think if an investor were after risk control primarily, then fixed capital value investments like a cash ISA might be a reasonable choice. That would certainly reduce financial and emotional risk. Or you could go the more efficient market route and have the rest of the portfolio made up of government and corporate bonds, REITs and commodity ETFs or similar.
But personally I have a (hopefully) long time horizon and I understand equities better than any other asset class, so I’m happy to be 100% for the foreseeable future.
Thanks for your answer. A followup question – if you felt the market was getting overpriced, would you sell out (some) of your positions and keep the money as cash?
Hi Bob, I might be inclined to hold slightly more cash, but not to the extent that I’d consider it “tactical asset allocation”. As you can see in the table in this post, I do have a ‘system’ for swinging into and out of cash, but I see that as primarily a risk reduction strategy rather than one which will enhance gains. I’m still interested in maximum gains while keeping risk below that of the wider market, so I would want to hold as much equities as possible at all times.
I think that even in the biggest bull markets there are still pockets of value. That was the case in the dot com boom, where funds such as Neil Woodford’s took off afterwards because they were holding all the solid but out of favour stuff, that came back into favour after the tech boom ended.
So as long as you’re focused on the intersection between quality and value I think staying in equities is better than trying to move – even slightly – in and out of cash.
Hi John,
Great article, as usual.
I’ve been trying to find a regular source of CAPE for different indices especially after reading Dominic Picarda’s article in the IC in November, but other than the incidental article here and there comparing CAPEs of markets, I can’t find anything that’s accessible to a retail investor.
Do you perhaps have any ideas?
Thanks Richard, I’ve had the same problem as well. To get current international CAPE valuations it seems to be a case of searching for recent articles on the subject. As for longer-term means, Meb Faber published a paper a while ago that had mean data on (I think) 29 countries, here:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2129474
The means are based on data going back to the 70s, so quite a short period of time, but that’s all anybody seems to have! One interesting point is that the UK very-long-term CAPE mean is about 12! I doubt that that will be the mean for the 21st century. I think that’s a good example of what makes this such an inexact science. It isn’t physics, and what was true for the last century isn’t necessarily going to be true for the next one.
Fortunately for us, gravity appears to be a bit more consistent.