In the past, I have generally stayed away from making stock market forecasts over a one-year period because, for the most part, they are little more than guesses.
However, this year I’m going to throw my hat into the forecasting ring in the hope that somebody, somewhere, will find it useful.
A CAPE-based forecast
To start with, all of my FTSE 100 valuation ideas are based around Robert Shiller’s CAPE (Cyclically Adjusted PE ratio), which uses ten-year inflation-adjusted earnings in the ratio rather than last year’s earnings as is the case with the standard PE ratio.
With the FTSE 100 at 6,061 points at the close of Wednesday (16/12/2015), the CAPE ratio (based on data that I have collected) stands close to 11.7.
My working assumption is that the long-term average value for CAPE is 16, an assumption which is based on more than 100 years of data that Shiller has for the S&P500 on his webpage).
That average value is important because markets tend to revert back towards their long-term average value given enough time.
So with the FTSE 100’s current CAPE at 11.7 and the long-term average (also known as fair value) CAPE at 16, my base assumption is that the FTSE 100’s CAPE ratio will head back upwards towards that long-term average.
Given that basic picture, the next question is:
By much do I think the market’s CAPE will move back towards its average by the end of 2016?
Forecasting the FTSE 100’s CAPE ratio for 2016
I could, for example, assume that the market’s CAPE ratio will be back at 16 within a single year.
To make a forecast on that basis it would be helpful to know the FTSE 100’s current cyclically adjusted earnings (ten-year inflation-adjusted average).
Those earnings are equal to the index level divided by CAPE:
Cyclically adjusted earnings = 6,061 / 11.7 = 517 index points
The answer is in index points, which is a strange unit (compared to pounds, for example) but it’s perfect in this context.
With those earnings and a CAPE ratio of 16 the FTSE 100’s fair value can be calculated as:
FTSE 100 current fair value = 517 * 16 = 8,272
Putting the FTSE 100’s current fair value at 8,272 may seem excessive, but at that level, its dividend yield would still be 3%. that’s a fairly typical yield, so 8,272 is really not expensive at all.
However, the market is not expected (by me or others who dabble in CAPE-based market forecasts such as GMO) to revert to its mean value in a single year. The usual expectation is that it will take somewhere between five and ten years, depending on how far away the market’s current CAPE value is from its long-term average.
On a more practical level, I don’t expect the FTSE 100 to breach 8,000 by the end of next year, although of course, I could be wrong.
So, how much might the market move in a single year?
I think a reasonable guess is that the market will move 50% towards its fair value in any given year.
At that rate, it would take about five years for the market to move from extreme overvaluation or undervaluation (which I define as a CAPE value which is double (32) or half (8) of fair value respectively) back to fair value.
For example, at the end of 1999, the FTSE 100 stood at 6,666 and its CAPE was indeed at 32. Using this assumption that the market’s CAPE will move halfway back towards its long-term average over the following year, the forecast for CAPE at the end of 2000 would have been 24.
With a forecast CAPE ratio of 24 at the end of 2000 the FTSE 100 would have had a value of 5,000. That’s a pretty bearish forecast, especially given the euphoric environment at the time for stock market investors. But it was also broadly correct.
Of course most of the time this forecast will turn out to be wrong, but for me that just means the market has got it wrong rather than the forecast being wrong.
Using that 50% move towards fair value idea, I can now forecast the FTSE 100 CAPE ratio for the end of 2016 by calculating the mid-point between its current value and fair value:
2016 Forecast CAPE = (16 + 11.7) / 2 = 13.9
Now that I have a forecast for the FTSE 100’s 2016 CAPE ratio, the last piece of the puzzle is to forecast what its cyclically adjusted earnings will be at the end of next year. After all, those average earnings may be 517 index points today, but that’s unlikely to be the case a year from now.
After that, all I’ll need to do is multiply that earnings forecast by the CAPE ratio forecast to get the final FTSE 100 forecast.
Forecasting the FTSE 100’s cyclically adjusted earnings
My CAPE data, which goes back to 1987, shows that the FTSE 100’s cyclically adjusted earnings have increased in every year except 1999 and 2015.
The ten-year average earnings dropped this year because the FTSE 100’s real earnings in 2015 (361 index points) were far below their level in 2005 (505 index points).
I expect the same thing to happen next year.
In 2006 the FTSE 100’s real earnings were 597, driven by the credit boom. However, for the last few years, earnings have been below 500 index points and I expect that to continue. So 2016’s real earnings are likely to be less than 2006’s, which will drag down the cyclically adjusted earnings figure.
I think a reasonable assumption is that the FTSE 100’s earnings in 2016 will be close to the average of the last decade (which is 517), so my guess for next year’s earnings is:
2016 Forecast for FTSE 100 earnings = 500 index points
That is a complete guess, and the real value could well turn out to be much less than that, but it’s a reasonable guess and is good enough given the amount of uncertainty in any forecast.
Putting that 500 value into the list of real earnings from 2006 to 2016 gives the following:
2016 Forecast for FTSE 100 cyclically adjusted earnings = 510 index points
So here I’m forecasting that the fair value of the market (which is a multiple of those cyclically adjusted earnings) has dropped slightly, as indicated by the decline in cyclically adjusted earnings from 517 in 2015 to 510 in 2016.
Forecasting fair value for 2016
Now that I have some average earnings to work with, it’s easy to forecast fair value for the end of 2016 by multiplying that average earnings forecast of 510 by the fair value CAPE of 16:
2016 Fair value forecast for the FTSE 100 = 8,160
So my 2016 fair value forecast is still north of 8,000, which for me means we are unlikely to get there in just one year.
Okay, enough with the preamble (unless you skipped it), let’s have a look at the actual forecast.
Forecasting the value of the FTSE 100 for the end of 2016
To get the actual forecast, where I assume the market closes half the gap between its current CAPE and fair value CAPE, I can just multiply the forecast cyclically adjusted earnings of 510 by the forecast CAPE of 13.9.
That, to the nearest 100 index points, gives the following final result:
FTSE 100 forecast for the end of 2016 = 7,100
Not exactly earth-shattering, but it’s an entirely reasonable forecast and is a fair indicator of my slight bullishness for the UK market over the medium term.
It will of course turn out to be wrong, but the underlying ideas are still sound and I think this is a useful exercise which will become much more useful when the market reaches extreme valuations.