UK stock market forecast – Q3 2015

I’ll start this UK stock market forecast with the FTSE 100 as that’s the index most people think of when they think of the UK stock market.

But before I begin – a couple of points:

1. I only make long-term forecasts, so I’ll be talking about what the market might return over the next ten years rather than the next year or two.
2. By “forecast” I mean the Expected Value of the market’s total return. In other words, an estimate of the average return the market would produce if we could run through the next ten years multiple times (which, according to the known laws of physics, we can’t).

FTSE 100 forecast: Expected ten-year total return of 10% a year

Today the FTSE 100 stands at 6,350 with a dividend yield of 3.8%. That’s slightly higher than its long-run average yield, which is closer to 3%.

As a result of that slightly high yield, the FTSE 100 is, at least from that point of view, slightly cheap and somewhat attractively valued relative to historic norms.

My preferred approach to forecasting the stock market’s return is to assume normal inflation, normal real (inflation-adjusted) dividend growth and a normal dividend yield.

So here are some basic assumptions:

• Inflation to 2025: 2% a year
• Real dividend growth to 2025: 2%
• FTSE 100 dividend yield in 2025: 3%

Those are all reasonable and fairly conservative assumptions and they represent my best estimate of what the next decade might look like.

With today’s FTSE 100 at 6,350 points and with the dividend yield at 3.8%, its dividend payment is currently 244 index points.

If that dividend grows by 4% a year for ten years (2% inflation plus 2% real growth) then by 2025 the dividend will have reached 344 points.

If the FTSE 100 has a 3% dividend yield in 2025 then with a dividend of 344 points it will have reached a level of 11,470.

That’s equivalent to a 6% annual capital gain, which is 2% from inflation, 2% from real dividend growth and 2% a year from the contraction of the dividend yield (and therefore the expansion of the ratio between price and dividend).

On top of that capital gain, we can reasonably expect an average dividend yield of between 3% and 4%, giving a forecast total return to 2025 of just under 10% a year.

Another valid approach to forecasting the market’s return is to use cyclically adjusted earnings, i.e. the inflation-adjusted ten-year average earnings. This is a metric that you may be familiar with from Robert Shiller’s CAPE ratio.

Currently, the FTSE 100’s CAPE ratio is (according to my data) 11.9, which means its cyclically adjusted earnings are 532 index points.

Here are my assumptions for an earnings-based forecast:

• Inflation to 2025: 2%
• Real cyclically adjusted earnings growth to 2025: 2%
• FTSE 100 CAPE ratio in 2025: 16 (approximately the historic average)

With those assumptions, the FTSE 100’s cyclically adjusted earnings will hit 787 by 2025.

If the FTSE 100 has a CAPE ratio of 16 then it will have reached the level of 12,592.

So the cyclically adjusted earnings-based forecast comes out quite similar to the dividend-based forecast, which is not a huge surprise.

If the market reached that level then the capital gains would be about 7% a year, and total returns would be 10% or 11% a year including dividends.

The average of those two forecasts is for a market level of 12,000 and a total return of about 10% a year, so that’s my forecast for the FTSE 100 through to the end of 2025.

FTSE 250 forecast: Expected ten-year total return of 7% a year

In the same way, it’s possible to produce a forecast of the FTSE 250’s total return to 2025.

The FTSE 250 differs from the FTSE 100 in that historically it has had slightly faster dividend and earnings growth and slightly higher valuation multiples (and therefore lower yields).

On that basis, my assumptions for the FTSE 250 are:

• Inflation to 2025: 2% a year
• Real dividend and cyclically adjusted earnings growth to 2025: 3% (slightly higher growth than the FTSE 100)
• FTSE 250 dividend yield in 2025: 2.5% (slightly lower yield than the FTSE 100)
• FTSE 250 CAPE ratio in 2025: 20 (slightly higher expected ratio than the FTSE 100)

So here are the calculations:

Currently, the FTSE 250 is valued at 16,900 points with a dividend yield of 2.5% and a CAPE ratio of 22.7.

With those values, the FTSE 250 has a current dividend of 425 index points and cyclically adjusted earnings of 744 points.

With 5% nominal growth of its dividend and earnings (2% inflation plus 3% real growth), the FTSE 250 will have a dividend of 692 points and cyclically adjusted earnings of 1,212 points in 2025.

Under those conditions:

• If the FTSE 250 has a dividend yield of 2.5% in 2025 it will have a value of 27,700
• If the FTSE 250 has a CAPE ratio of 20 in 2025 it will have a value of 24,200

A reasonable forecast for the FTSE 250 in 2025 is therefore the average of the two, which is approximately 26,000.

That would give the FTSE 250 capital gains of 4.5% a year, with total returns closer to 7% when dividends are included at an average yield of 2.5%.

On that basis, the expected total return of the FTSE 100 is better than the expected return of the FTSE 250 over the next ten years.

Of course, while the expected value of a dice roll is 3.5, you cannot actually roll a 3.5, and even if you could, you would not expect to roll a 3.5 every time.

In the same way, these forecasts are my expected value for the UK stock market’s total return over the next ten years, but that does not mean I expect the market to precisely match these forecasts.

However, if I had to put money on one of those indices beating the other, I would back the FTSE 100 over the FTSE 250.