Once again the FTSE 100 has come eye-wateringly close to a new all-time high. By now this shouldn’t be big news because it’s been happening for almost all of 2014.
So what does it all mean? Is the FTSE 100 cheap, expensive, about to begin a massive bull run like the S&P 500 or enter a new bear market like it did in 2000 and 2007?
FTSE 100 price charts seem to suggest a massive bear market is looming
Have a look at the price chart below and you’ll see a price pattern that is hard to ignore:
If you’re like most people your brain will immediately tell you that the market has swung between approximately 3,600 and 6,800. It takes 4 or 5 years to climb up and then 2 or 3 years to fall back down again.
There appears to be some form of invisible resistance above 6,800, or thereabouts, which stops the market from climbing higher. On the other hand, an invisible support seems to lurk below 3,600, stopping the market from falling any further.
This pattern is virtually unmissable. But it’s also irrelevant. In fact, it’s worse than irrelevant, it’s misleading.
Focusing on price history alone is like focusing on the price history of a house without knowing anything about the house itself.
Perhaps someone bought a house for £100,000 a decade ago and today they sold it to someone else for £200,000. What does that tell you about the sort of price rise the new owner could expect in the next 10 years or so? It tells you nothing.
For that you’d need to know what sort of house it was, where it was, what sort of rent it could rent it could command as a buy-to-let investment and many other factors.
Price is simply the amount that somebody else was willing to pay for an asset at some point in the past. Without some information about the underlying asset, it is pointless to try to infer things about the future from past prices alone.
In the long run, prices follow profits
What matters is not whether or not the price is high relative to past prices, or whether we’re at a new high, but whether the price is high relative to the factors that drive price, and the primary driver of price in the long run, for both stocks and property, is earnings.
If we take a look at the cyclically adjusted earnings of the FTSE 100 as a whole (i.e. the 10-year average of inflation-adjusted earnings) then we can see another pattern. This time it isn’t one that bounces up and down between two points like the price pattern, but is instead a pattern of steady, progressive growth.
The FTSE 100 price level uses the left axis while its cyclically adjusted or “smoothed” earnings are on the right.
The axis for the price level is set at 16 times that of the smoothed earnings because, over the long term, investors have been willing to pay approximately 15 times the index’s smoothed earnings. This multiple is the well-known CAPE (cyclically adjusted PE) ratio from Robert Shiller.
The three most important words in investing are valuation, valuation, valuation
As you can see in the chart above, the FTSE 100’s price has been fairly close to 16 times its cyclically adjusted earnings in most years. When it has moved far above that level, as it did at the end of the last century, returns going forward have been less than generous. On the other hand, when the multiple has been far below 16, as it was in the crisis year of 2009, returns have been much higher.
This is a general pattern that we see in markets around the world; they hover around some central average CAPE figure, which for most markets most of the time is something like 15 or 16.
This isn’t a rule or law of physics, but it’s been a reliable guide for more than a century, so it definitely has some validity as a practical rule of thumb.
What it isn’t though is a guide to where the market will be this year or next (or the year after that, or even the year after that). The market is too efficient and random for that and one person’s guess is as good as another.
What we can say though is that there are certain long-term trends where it’s reasonable to assume that they continue:
- Inflation – It’s reasonable to assume that we have inflation at perhaps 2% a year for the foreseeable future.
- Real growth of profits (and dividends) – Another trend is real (after inflation) growth in corporate earnings and dividends. This also has a long-run historic average of around 2% a year.
- Valuation mean reversion – The final trend is that over time CAPE has an average value of 15 or 16, and so that’s a reasonable best guess for the market’s valuation multiple 10 years from now.
If the market’s CAPE is below average today then we’ll have a tailwind as CAPE increase back to its average. That will drive the market upwards faster than the growth in underlying earnings. If the FTSE 100’s CAPE is above average then that same mean reversion becomes a head-wind and the market’s price will increase more slowly than earnings.
So what does all this talk of valuation multiples and CAPE have to do with the market bouncing between 3,600 and 6,800, and why does it mean that a fall back to 3,600 is unlikely, even though we’re at near record highs?
If you look at the second chart you can see that in 2000 the price was way above the earnings line. In other words, CAPE was well above 16; in fact, it was nearer 32. Again in 2007, the price was above the earnings line and so above a valuation multiple of 16; this time it was priced at 20 times smoothed earnings.
Today, even though the price is at the same level as those two prior peaks, corporate earnings and dividends have continued to increase and so now the price is below that earnings line. CAPE is now just 13.3 and comfortably below its long-run average.
The FTSE 100 is now back to where it was in 2000, but the earnings of the underlying companies have more than doubled in that time making today’s price quite reasonable in valuation terms. That’s why it’s so important to not just look at the market’s price but to also take into account the productive output of the underlying asset that you’re investing in, i.e. the earnings, dividends and so on.
Decent future returns are a reasonable expectation, despite the FTSE 100’s near-record level
Today the total of the FTSE 100’s cyclically adjusted earnings are equivalent to approximately 515 index points. Each index point is worth about £250 million, so very approximately those 100 companies have earned an inflation-adjusted, combined average of £131 billion per year.
If we assume that the earnings of those 100 companies grow at a historically normal rate which is 2% faster than inflation, which also runs at 2%, then in 2024 those earnings will have reached 760 index points (about £194 billion per year).
Apply to those earnings the average CAPE multiple of 16, an amount that investors have typically been willing to pay to buy those earnings, and you end up with a FTSE 100 value of just over 12,000 in 2024. I won’t try to be any more accurate than the nearest thousand because it’s impossible to be precise about the future of the market.
So in the short-term, it’s impossible to tell where the market is going, but in the longer term we can see what sort of range of values would be reasonable, and 12,000 is currently my “central projection” for the FTSE 100 a decade from now, which is the sort of timespan a long-term investor should be concerned about.
I’ll leave you with my FTSE 100 “heat map” which shows the range of 10-year future returns implied by various market valuation levels over the last 25 years. It also shows what the FTSE 100 actually was at the time. If the market was in the red then the implication was that future returns would be bleak, yellow implies average returns and green implies good returns.
Today the FTSE 100 sits in the light green band, with projected future real returns of 6% to 8% per year over the next decade with dividends reinvested (or 8% to 10% if you include inflation at 2%).
Excellent article.
Is there a public source for historic dividends paid by the FTSE100 in absolute terms please?
Thanks Jonathan. If you mean absolute in Sterling terms then the Capita Dividend Monitor is the only one that I can think of.
You can either do an online search, in which case you’ll probably see a few of the most recent issues. Or use the link below and scroll down until you see the latest issue.
http://www.capitaassetservices.com/news-and-opinion.cshtml
You’ll have to dig around a bit to find the numbers, and look at old issues to get the numbers for each index.
E.g. in Issue 18 (Jan 2014) it says that total UK plc dividends for 2013 were £79.8 billion, which breaks down as £70.7 billion from the FTSE 100, £7.5 billion from the FTSE 250 and £1.6 billion from small caps.
Hope that’s of some use.
reassuring article. thanks.
Hi Dawn, not too reassuring though I hope! It’s a good idea to remain cautious at all times, at least to some extent, and no matter how benign the markets may look.
Really interesting article -thanks.
What I think would be even more revealing is if you could compare your historical “10 year real annual return” projections with the 10 year real annual return projections of the alternative asset class of bonds. When you consider at the previous 2 peaks the 10 year gilt was pricing a 5% yield and currently it prices under 2%, the relative return potential looks crazy.
Hi Chris, I must say I’m not really much of an expert on bonds, I’m an equities man through and through. If you want to dig up the data on historic bond yields and add a link to a chart or something of the comparison to equity yields then you’re more than welcome.
If you look at Robert Shiller’s spreadsheet then he has 10-year US government bond yields going back to 1880. Not sure where similar data is for the UK.
Very interesting article. The last ten years have been rather anomalous (massive financial crisis, state interventions, etc.). Can we still use the CAPE (that takes into account the last ten years’ earnings for each company)? Or should we apply some adjustment for this anomaly when we compare CAPE present values to historical ones? Thanks.
That’s a point which comes up quite often.
Personally I don’t make any adjustments as future returns are so uncertain that any effort to fine tune the data to take account of this factor or that factor is probably just fiddling for fiddling’s sake. I don’t think it would materially improve CAPE’s predictive power.
Thanks for your reply. The other very anomalous event of the last few years is QE, which has probably inflated earnings (and everything else). I guess inflation is automatically corrected for when one divides earnings by share prices, but still it may be argued that in a money-printing environment the CAPE may be expected to be different from “normal” times?
Yes, I’d definitely say that QE has impacted CAPE, but how much and how long it will continue is very hard to say. If I made various adjustments for this or that (QE, imported deflation from China, peak oil, climate change, robots, etc) I don’t think they’d necessarily be any better than the plain vanilla CAPE.
John, Interesting article and I’m hoping it’s correct.
I’d make a couple of cautionary points about the possibilities behind these projections :-
There is a backdrop of low interest rates and therefore cheap money companies have had the luxury of during the last 10 years, and this has helped the performance many of these companies have shown (or at least the last 7 years).
Earnings can be rather subjective and it’s perhaps better to look at how these have arisen. My point 1 should be taken into account in helping to derive these earnings and these conditions may not exist in the next 10 years, hence the game could radically change if interest rates rise and the cost of money returns to a more normal level.
Many companies have grown earnings by increasing leverage, which is a consequence of cheap money and increasing debt. This calls into question the quality of these earnings. There’s an old saying – “I’ll give you all the earnings you like if you give me enough capital to play with”.
Revenues in some (not all, but some) have not risen as fast as the reported earnings, and in some cases have not risen at all, or even declined. I can only conclude from this that cost cutting is the driver for those earnings and not real business growth. How long can that go on?
last and very important point – “Dividends have “No” bearing on a companies value”
It’s more important than ever to focus on companies that have a high ROCE, can show manageable debt and are in a strong competitive or monopolistic or psuedo-monopolistic position.
Well that’s my two-pennies worth anyhoo!!
Hi LR, an excellent set of points (although as a dividend fan I disagree with #5).
The next decade will be interesting I’m sure, as the UK tries to get out of the low interest rate and low productivity corner it’s painted itself into.
Hi John,
I think we are both in agreement on having a good dividend portfolio, as long as the dividend is growing in line with the ability of the company to generate sufficient cash to cover it (not earnings which are a paper exercise for many companies). To the individual investor, the value of the dividend is important if you want to have an income as such, and that assuming selling some stock that has grown it’s capital value is too punitive from a CGT perspective.
However, I tend to agree with Messrs Modigliani and Miller that the dividend policy of a company has no effect upon its value.
Regards LR
Hi John,
This is interesting work.
I’m a big fan of the Shiller CAPE but have always struggled to find a UK based earnings series to create something similar.
Where have your sourced your data?
Paul
Hi Paul
I’m afraid the data isn’t institutional quality. It’s a big lumpy and slightly inaccurate the further back it goes. The data back to perhaps 2008 is based on the FT data:
http://markets.ft.com/research/Markets/Data-Archive
Just scroll down, select category ‘equities’ and report ‘FTSE actuaries share indices’ and you can see the FTSE 100 price, earnings and yield for any day you like.
But that only goes back so far, so beyond that I have used data found on the internet from various sources, which appear to be reasonable by cross-validating them and by using judgement.
It’s not perfect, but I think it’s ‘good enough’, and as you say official data is hard to come by unless you have a Bloomberg Terminal (although a couple of years ago somebody asked me for my data and said that it was better than Bloomberg’s!). As each year goes by the accurate data from the FT site will also become a larger portion of the data pie.
Here’s a sub-set of the data which is slightly out of data, but probably 99% the same as what I use now:
https://dl.dropboxusercontent.com/u/5236691/UKVI/FTSE%20100%20CAPE%20Data%202013%2009.xlsx
Interesting thanks,
I see that Hargreaves had a go at the UK CAPE recently also and it implied that the UK was very cheap but something doesn’t seem right there – because if you look at the USA – the CAPE has ranged (mostly) between 10 and 20 – with anything above that suggesting an overpriced market.
Whereas the Hargreaves chart suggests that at 15 the UK CAPE is cheap!
Then there is the Barclays work on sectorially adjusted CAPEs or SCAPES! which suggests that it’s okay for the US to maintain a higher CAPE than other countries because of their heavy weightings in high growth tech stocks – and that the UK should settle in a lower range because of our higher weightings in utilities and miners etc.
Bottom line – the UK doesn’t feel that cheap to me right now.
Best
I think HL must be saying that 15 is cheap in the context of the last 30 years, which it might be, but of course those 30 years included a long time at very high and bubble valuations.
Looking at the US as you say makes 10-20 seem like more normal levels, with 15 a reasonable ballpark estimate of ‘normal’. So today I think we’re ‘slightly cheap’, but the closer you get to normal valuations the less interesting things you can say about future returns.
SCAPES sounds like a fair approach, but CAPE in general is a pretty weak indicator; it’s just that most of the others are even weaker.