We’re halfway through the year so that can only mean one thing: It’s time to re-calculate fair value for the FTSE 100 and dip a toe into the mystic world of stock market forecasts.
FTSE 100 valuation: Almost at fair value
After an incredibly long and slow bull market, the FTSE 100 is, at last, getting very close to fair value.
“Fair value” is of course a subjective term. Personally, I like to measure it using Robert Shiller’s cyclically adjusted PE (CAPE) ratio.
If you haven’t heard of CAPE before, it’s the ratio between an index’s current price and its average inflation-adjusted earnings over the last ten years.
Fair value occurs when the CAPE ratio is close to its long-term average, which I estimate to be around 16 for the FTSE 100 (based on data from the FTSE 100, S&P 500 and other major indices).
As I write, the FTSE 100’s value is 7,378 index points and its inflation-adjusted earnings have averaged 493 index points over the last decade.
The ratio of price to earnings (7,378 to 493) is 15.0, so:
- The FTSE 100’s CAPE ratio is 15.0
15.0 is close to but slightly under the long-term average CAPE ratio of about 16, which means the FTSE 100 is close to but slightly under fair value.
Fair value, in this case, occurs when CAPE is 16, so:
- Fair value today for the FTSE 100 is 7,896
7,896 is only slightly above where we are today, so clearly the FTSE 100 is not in bargain territory. However, it also isn’t obviously overvalued, despite an eight-year bull market.
This isn’t always the case though. Sometimes an index’s value can reach as high as double fair value (as it did in 1999), or fall as low as half fair value (as it did in 2009).
In the long run though, current value and fair value never stray too far from each other, as the chart below shows:
The chart clearly shows the close relationship between the FTSE 100’s current value and its fair value.
My favourite analogy is that current value and fair value are connected by an invisible elastic band. It goes something like this:
When the market’s current value is far from fair value, there is a strong invisible force pulling it back towards fair value. This force can be overcome for a while by strong animal spirits, such as optimism during booms or pessimism during busts.
But strong animal spirits can only be sustained for short periods of time, perhaps a few years at most. And when those animal spirits weaken or reverse, the invisible force of mean reversion takes over and the market is pulled inexorably back to fair value.
In my opinion, mean reversion is the closes thing we have to gravity in the investment universe, which is why it’s central to all of my market forecasts.
FTSE 100 one-year forecast: Down, but not by much
First of all, I want to make a couple of points clear:
- I have no idea what the stock market is going to do over the next year and neither does anybody else. Rather than trying to actually predict what the market’s going to do (which is impossible), these forecasts are a useful way to visualise the opportunity or threat implied by the gap between the market’s current value relative to its fair value.
- Technically this is a projection, not a forecast. But most people use the term forecast to mean any sort of future-gazing, so I’ll stick with that informal term.
This forecast is based on the assumption that the market will halve the gap between its current value and fair value over the next twelve months. This means that a larger gap will result in a larger correction (either positive or negative), whereas a smaller gap leads to a smaller correction.
I think that assumption is reasonable and approximates what happens in the real world.
We can calculate the FTSE 100’s fair value for mid-2018 by assuming a couple of things:
- That inflation runs at 2% (the Bank of England target) and
- that the FTSE 100’s current earnings of 237 index points (based on its current price of 7,378 and its PE ratio of 31.07) are the same at the end of 2017.
Those two assumptions produce a figure for cyclically adjusted earnings in mid-2018 of 457 index points. That’s slightly down from the 493 we have today.
A forecast for falling cyclically adjusted earnings means that fair value is also forecast to fall.
Why would cyclically adjusted earnings and fair value fall rather than rise?
The reason is that cyclically adjusted earnings are based on a rolling ten-year average of earnings, and ten years ago we were at the height of the credit bubble.
Back in 2007, banks and commodity-related companies were earning vast profits and those two groups make up a significant chunk of the FTSE 100.
In inflation-adjusted terms, FTSE 100 earnings were 690 index points in 2007. Today they’ve fallen to just 237.
That is a massive decline and as the boom-year profits fall out of the ten-year average, they are being replaced by the much smaller profits that are being generated today.
That, in a nutshell, is why cyclically adjusted earnings and fair value are falling.
Given the lower level of earnings, we have this result:
- FTSE 100 forecast fair value for mid-2018 = 7,317
So the forecast is for fair value to fall by 7.3% from today’s fair value of 7,896.
It’s also 0.8% below today’s price of 7,378, so even if the market moved straight to fair value it would still decline in this scenario.
However, my forecast assumes that the market will not completely close the gap to fair value. Instead, it will close the gap by half over the next year.
So rather than CAPE moving from 15 (its current value) to 16 (fair value), it only goes halfway to 15.5.
As a result, we get:
- FTSE 100 forecast value for mid-2018 = 7,077
And so, after much ado, my forecast suggests that a reasonable guess for where the FTSE 100 will be in mid-2018 is 7,077, some 4% below its current value.
Not very exciting, but incredibly useful
I must admit that forecasting a 4% decline is not very exciting. In fact, it makes me think this forecast is kind of useless.
But it isn’t.
This forecast, however dull, contains within it some incredibly useful information:
First, that the market is very close to historically average valuation multiples, so investors should expect historically average returns.
Over the last century that’s been something like a 5% real return from the UK stock market. Or using the dividend growth model, adding the current dividend yield of 3.8% to the long-term real dividend growth rate (which is about 3%) gives a real return of almost 7%, or 9% nominal if we assume inflation remains close to 2%.
I think a 7% to 9% total return sounds reasonable (and perhaps even a little optimistic), so FTSE 100 index-tracking investors should not expect more.
Second, if the FTSE 100 continues to grow by 10% or more per year then it will soon become overvalued. This increases the risk of a bear market and reduces the dividend yield and long-term expected returns.
Third, even though this forecast may be dull, it is the habit of doing a regular comparison between the market’s current value and its fair value that matters.
It matters because one day the market will not be close to fair value. One day, like in 1999 or 2009, it will be very far from fair value, and it’s at moments like those that great fortunes are made or lost, and small ones as well.