The FTSE 250’s CAPE ratio suggests the index is close to fair value

It would be fair to say that in the immediate aftermath of the Brexit referendum, the FTSE 250 crashed. It fell by more than 13%, taking the mid-cap index back to levels first reached in the middle of 2013.

That all sounds pretty gloomy, and it was. But it didn’t last, and by the time I’d written a post-Brexit market review, things were already looking up (for the FTSE 100 at least).

Within a month or virtually all of the FTSE 250’s losses had been reversed and today the index sits very close to its all-time high.

I’m sure there are lots of stories which could be woven around this sequence of events, describing the whys and wherefores of the market’s unexpected post-referendum surge, but personally, I am not particularly interested in those stories.

What does interest me is the FTSE 250’s CAPE ratio (cyclically adjusted PE) and whether or not the index represents good value for money at its new higher price.

Why the CAPE ratio is a useful guide to future returns

I’m sure I’ve written about the CAPE ratio a hundred times, but here is a quick recap just in case you haven’t of it:

• CAPE is similar to the PE (price to earnings) ratio but uses inflation-adjusted ten-year average earnings rather than last year’s earnings (hence the name, “cyclically adjusted”)
• It is typically used to value market indices
• It is better at forecasting future returns than the standard PE ratio
• It has an average value somewhere between 10 and 20 for most stock markets around the world
• The CAPE ratio is mean reverting. If it is currently above or below average it can be expected to return to its average value at some point in the next few years
• As a result of mean reversion, if an index’s CAPE ratio is above average then it is more likely that the index’s ratio and price will fall, and vice versa
• Therefore, when CAPE is low, higher returns can be expected, and vice versa

In the case of the FTSE 250’s CAPE, my current estimate of its long-term average is 20, based on data going back to 1993.

So if the FTSE 250’s CAPE ratio is above 20 today, I would expect below-average returns in the next few years (and vice versa).

The FTSE 250’s price and CAPE ratio are slightly above average

At the time of writing the FTSE 250 stands at 17,195 and has a CAPE ratio of 22.8.

This is slightly above my estimate of its long-term average CAPE of 20, but only slightly. In fact, it is so close that I would still describe today’s price as a reasonably normal or fair valuation.

In other words, the FTSE 250 is not obviously expensive and it is not obviously cheap. It is, as Goldilocks might say, “just right” (or thereabouts).

The chart below shows how the FTSE 250’s CAPE ratio has changed over time relative to the kind of values it could have taken if the economy and investor sentiment were different.

If that rainbow has you scratching your head, here’s a quick summary:

• Green: Increasingly low/good valuations that occur when money flows out of the market during severe recessions and depressions
• Yellow: Average valuations where markets and investor sentiment are at normal levels
• Red zone: Increasingly high/bad valuations which occur when money floods into the market during economic booms

Just in case you were wondering, the CAPE rainbow heads upwards over the years because of inflation and because the underlying companies have grown in real (inflation-adjusted) terms as well.

For example, between 1993 and today, the FTSE 250’s cyclically adjusted earnings have grown faster than inflation by an average of 5.2%.

If the idea of cyclically adjusted earnings growing over time seems a bit odd then hopefully the chart below, which shows the FTSE 250’s annual earnings and dividends increasing over the years, is a bit clearer.

My expected return for the FTSE 250 over the next year is close to zero

I’m not much into forecasting, but I do like to calculate a one-year expected value and expected return for the major indices.

This can be a worthwhile activity if you stick to a few reasonable assumptions, avoid wild speculations and view the outcome as indicative rather than predictive.

For the FTSE 250, my reasonable assumptions are:

• Earnings growth: Cyclically adjusted earnings will grow at their historically average rate
• Mean reversion: The gap between the FTSE 250’s current CAPE ratio and its average CAPE ratio to be closed by half
• Dividend paid: The FTSE 250’s dividend yield of 2.7% will be paid in full

On the first point, the historic earnings growth rate has been 5.2% after inflation, so if I estimate inflation at 1% then the assumed earnings growth will be 6.2%.

The FTSE 250’s cyclically adjusted earnings are equal to 755 index points today, so a year from now I’m assuming they’ll have reached 802 index points.

On the second point, halving the gap between a CAPE of 22.8 and a CAPE of 20 would give a CAPE ratio of 21.4.

With those two pieces of information, it’s now easy to calculate an expected value for August 2017 and the expected capital and total returns:

• FTSE 250 expected value = 802 * 21.4 = 17,146
• FTSE 250 expected capital gain = – 0.3%
• FTSE 250 expected total return = – 0.3% + 2.7% = 2.4%

To be honest, that’s a pretty boring “forecast”, but at least it shows that the mid-cap market is not horrendously overvalued and that its expected return is not seriously negative.

However, I don’t think I’ll be switching from active stock picking to passive index tracking anytime soon.