My FTSE 250 forecast for 2016

This FTSE 250 forecast will be based on the same approach as the FTSE 100 forecast I published in December. In other words, it will be based on numbers and historic averages rather than gazing into an invisible crystal ball.

As I have already covered the forecasting methodology in some detail in that FTSE 100 forecast, I’ll just summarise it here:

• The ratio between a stock market index’s price and its ten-year inflation-adjusted average earnings (known as CAPE, for cyclically adjusted PE ratio) tends to stay within a range of about half to double its long-term average
• CAPE tends to head back towards its average value when it is above or below that value, given enough time (which is known as mean reversion)
• If CAPE is high it’s more likely that the index will fall (and therefore lower the CAPE ratio), and vice versa
• I assume that the gap between an index’s current CAPE and its long-term average CAPE will close by about half over a one-year period

Calculating FTSE 250 cyclically adjusted earnings

The first thing I need to know to make this forecast is the FTSE 250’s cyclically adjusted earnings at the end of 2016.

Its current cyclically adjusted earnings at the end of 2015 were 754 index points. That’s the average of its inflation-adjusted earnings over the last ten years, which comes from the earnings data shown in the chart below.

You can easily calculate an index’s earnings by dividing its price by its PE ratio, and you can find the price and PE ratios (and dividend yield) for the FTSE 250, FTSE 100 and other indices on the FT website by using the address below to download a PDF chock full of data (price and PE are in the FTSE Actuaries Share Indices section):

• World Markets at a Glance (ft.com)

You can change the date at the end address to whatever you like, although it won’t load (I think) if it’s a weekend date or before mid-2015 or thereabouts.

If you want older data go to the FT Data Archive page and scroll down to where it says “download reports dated prior to 2015”, select Category “equities” and Report “FTSE Actuaries Share Indices”.

For example, using the FT Archive data, the FTSE 250 at the end of 2015 stood at 17,430 and had a PE ratio of 20.15. Dividing the price by the PE ratio puts the index’s year-end earnings at 865 index points (which is the latest data point in the chart above).

To forecast cyclically adjusted earnings for the end of 2016 I need to forecast the index’s one-year earnings for the end of 2016. To do that I have simply multiplied its current earnings of 865 by my estimate of next year’s inflation which is 2% (this estimate is bound to be wrong, but it’s still a reasonable estimate).

That gives a forecast of one-year earnings for the end if 2016 of 865 * 102% = 882 index points.

Using that number along with the inflation-adjusted earnings from the previous nine years gives the following result:

2016 FTSE 250 cyclically adjusted earnings forecast = 767 index points

Forecasting fair value for the FTSE 250

Now that I have a figure for cyclically adjusted earnings at the end of 2016, all I need to do is multiply that earnings number by the forecast CAPE ratio to reach my forecast index price.

I’ll start with a forecast of fair value, which is another name for the index’s price when CAPE is at its long-run average, and where the ratio and therefore the index is not expected to mean revert either upwards or downwards.

Since 1993, which is the period for which I have data of varying quality (newer data is from the FT data archive, older data is from less reliable sources and in some cases partly estimated). Since that time the FTSE 250’s median (i.e. middle) CAPE ratio has been 23.1.

That is some way above the 100-year median CAPE ratio for S&P 500, which is 15.8 (you can get the S&P 500 data from Professor Robert Shiller). It is also above the median FTSE 100 CAPE since 1987 of 19.0.

My guess is that the FTSE 100’s long-term CAPE of 19 would be much closer to the S&P 500’s if I had sufficient historic data. In lieu of that data, I usually assume that the FTSE 100’s long-term median CAPE is actually 16 rather than 19.

In the same way, I don’t think the FTSE 250’s true long-term median CAPE is 23.1. It is also likely to be lower as we have seen two massively overvalued bull markets in the last 20 years, with the FTSE 250 CAPE peaking close to 32 at the end of 2006.

I think a reasonable estimate of the FTSE 250’s actual long-term average CAPE is 20. That’s a bit of a wild guess, but I imagine it’s in the right ballpark.

Given that my fair value CAPE for the FTSE 250 is 20, I can make the following forecast, by multiplying my forecast of cyclically adjusted earnings by my estimate of fair value CAPE:

2016 FTSE 250 fair value forecast = 767 * 20 = 15,338

So my estimate of fair value is some 12% below where the FTSE 250 stands today. On that basis, the mid-cap index is overvalued, but only slightly.

However, I don’t expect the index to revert to fair value within just one year (although it easily could, as fair value is not that far away). Instead, I assume that the index’s CAPE ratio will close just half of the gap between its current value and its fair value, at which point it will have reached what I call its expected value.

Forecasting expected value for the FTSE 250

And so after an extended introduction, this is my actual forecast for the FTSE 250 at the end of 2016. I expect its CAPE to move halfway back towards fair value from its current value, in other words, expected CAPE is the average of current and fair value CAPE.

The FTSE 250’s current CAPE is 23.6, so that produces the following result:

2016 FTSE 250 expected CAPE = (23.1 + 20) / 2 = 21.8

With an expected CAPE ratio of 21.8 by the end of 2016 and forecast cyclically adjusted earnings of 767, my forecast of the FTSE 250’s expected value by the end of 2016 is:

2016 FTSE 250 expected value forecast = 767 * 21.8 = 16,713

So my expected value for the mid-cap index is slightly down on where it stands today (at 17,430), but only by about 4%.

Given that the FTSE 250 is so close to my estimates of both its 2016 expected value and fair value, I do not see any obvious reason to be either especially bullish or bearish about that index.

On balance, I would describe myself as being very slightly bearish about the FTSE 250, unlike the FTSE 100 (based on my FTSE 100 forecast), where I am slightly bullish.