Who’s right about the UK stock market?
- Is it the bulls, who think the UK market is attractively valued and could easily double if investors fall in love with stocks again?
- Or is it the bears, who see the FTSE 100 at record highs and a near-decade-old bull market which must be well into old age by now?
But first, a caveat:
With that bet-hedging caveat out of the way, I’ll review the bear case and then make the counterarguments that a devout bull might give.
Making and then rejecting the bear market case
As an investment newsletter writer, I get to speak with lots of private investors. Many of them are bears at the moment and the three most common reasons they give are:
1) The bull market is already very old
The bear case:
This bull market started in early 2009, which makes it nine years old. This is unnerving because bull markets don’t usually last much longer than this.
For example, since 1926 US bull markets (PDF) have lasted an average of nine years and the longest was 15.1 years. Closer to home, the FTSE 100’s longest bull market since 1984 was the 11-year period between late 1987 and 1998.
Given the typical length of a bull market, it is very likely that a bear market is just around the corner.
The bull’s rebuff:
The bull market isn’t nine years old because technically it ended in early 2016. Between April 2015 and February 2016, the FTSE 100 fell from 7,100 to 5,537, a fall of 22% (a bear market is a decline of 20% or more).
It was a short bear market which lasted less than a year, but rules are rules: It was a bear market so the post-crisis bull market actually lasted from 2009 to 2016, a fairly typical seven-year period.
This means the current bull market started in February 2016, so it’s only just over two years old. Therefore, the argument that we are “due” a bear market does not hold.
2) The FTSE 100’s PE ratio is insanely high
The bear case:
In September 2016 the FTSE 100’s PE ratio reached an astonishing 39.6, which is more than double its long-term average of about 15.
And this wasn’t a one-off event. Across the whole of 2016 and 2017, the FTSE 100’s average PE ratio was 29.8, an insanely high figure.
A PE ratio of more than 30 is about as clear a signal of overvaluation as you’re likely to get.
And although the PE ratio has declined from those extreme highs, it was still around 25 at the end of 2017, so the risks have not gone away.
The bull’s rebuff:
All of that is true. The FTSE 100’s PE ratio was above 30 for a long time and almost reached the eye-watering level of 40 just over a year ago. In fact, the index’s price is higher now than it was when the PE was almost 40.
However, the PE ratio is the ratio between the index’s price and the most recent one-year earnings of its constituent companies.
The key point is the one-year earnings figure.
It is an unavoidable fact that the earnings of most companies are volatile from one year to the next. Changes of 50% or more in either direction over a 12-month period are extremely common.
The upshot is that the earnings of the FTSE 100 are also volatile from one year to the next. Yes, the index’s earnings are more stable than most companies because they’re effectively the average earnings of 100 companies, but they’re still volatile.
What does volatility have to do with the FTSE 100’s high PE ratio?
Everything. Since 2015 the FTSE 100’s price hasn’t really changed much. It was about 7,000 in early 2015, and in late 2016 and it’s still at that level today. However, in early 2015 the index’s PE ratio was 16, in late 2016 it was 40 and today it’s much lower (I’ll mention how low in a minute).
So the price has barely changed and yet the PE has doubled and then halved. Why? Because the index’s on-year earnings have been all over the place.
Below is a chart showing the FTSE 100’s earnings over the last three years. The period of very high PE ratios coincides with a relatively short period of abnormally low profits, largely driven by a collapse in commodity-related profits from miners, oil producers and similar companies.
I’ve included the dividend to show you how volatile one-year earnings are compared to dividend payments:
As you can see, the collapse in earnings didn’t last, and more recently the FTSE 100’s earnings have rebounded dramatically.
And in case you’re wondering whether today’s earnings are abnormally high, they’re not. At 540 index points, today’s earnings are only slightly above the FTSE 100’s inflation-adjusted ten-year average earnings of 470, and they’re well below the index’s peak inflation-adjusted earnings of 700, produced way back in 2008.
Today, with a price of 7,000 and earnings of 540, the FTSE 100’s PE ratio is 13, slightly below its long-term average. So the argument that the FTSE 100’s PE ratio is a sign of overvaluation does not hold either.
3) The US market is likely to crash and take the UK with it
The bear case:
Most investors seem to agree that the S&P 500 (the US large-cap index) is very expensive, whether based on PE, CAPE or dividend yield.
But as a UK investor I don’t care what the French stock market does, so why should I care about the US market?
You should care because there’s an old saying: When the US sneezes the rest of the world catches a cold.
Of course, this has more to do with the size of the US economy rather than the spread of flu viruses. However, on the face of it, this old wives tale seems to hold because both the US and UK stock markets have (more or less) had:
- Bull markets from 1984 to 1999 (ignoring the short and shallow bear market of 1998)
- Bear markets from 2000 to 2003
- Bull markets from 2003 to 2008
- Bear markets from 2008 to 2009
- and now bull markets from 2009 to 2018 (again, ignoring the short FTSE 100 bear market in 2015/16)
It’s like the US and UK stock markets are joined at the hip.
Since the US market is so obviously expensive, it is likely to suffer a crash and that crash would take the UK market down with it whether the UK is expensive or not.
The bull’s rebuff:
Let’s assume that the US market does crash and that the FTSE 100 does go down with it.
Let’s also assume this is a proper bear market and not just a technical one. A technical bear market is a 20% decline, but few investors really care about such minor falls, especially if they take place over many months rather than a few days.
A proper bear market is one that scares the living daylights out of most investors. I would say that level of fear requires a fall of 30% or more. That’s a reasonable figure because the average US bear market decline has been between 30% and 40%, according to this detailed analysis of US bear markets (PDF).
Today the FTSE 100 has a dividend yield of 4.2%, a PE ratio of 12.9 and a CAPE ratio of 14.8, compared to long-run averages of around 3%, 15 and 16 respectively.
All of those valuation metrics are currently below their long-run averages, so the FTSE 100 is already very probably slightly cheap.
Here’s where a 30% decline from today’s price of 7,000 would leave the index:
- FTSE 100 = 4,900
- Dividend yield = 6%
- PE ratio = 9
- CAPE ratio = 10.3
Those numbers are seriously attractive. The FTSE 100 with a dividend yield of 6%; how long do you think that would last? Investors would literally be chewing their arms off to get a 6% yield from the FTSE 100.
They would only be kept away by extreme fear, and extreme fear doesn’t usually last very long. Once its gone, investors would flood back into the market and push the price up and the yield down in no time, just as they did in the dramatic post-2009 rebound.
That’s a reasonable scenario for a 30% decline. However, many bears are talking about a possible 50% decline like the ones we saw after the recent dot-com and credit bubbles.
So what would a 50% decline do to the FTSE 100? Here are the numbers:
- FTSE 100 = 3,500
- Dividend yield = 8.4%
- PE ratio = 6.4
- CAPE ratio = 7.4
Those are literally Great Depression numbers.
The only time we’ve seen anything like that in the past is when millions of people have been homeless and the whole economic system has basically collapsed. Not might collapse, but actually has collapsed.
If you’re a shotgun and beans type of person then this might seem like a risk worth worrying about, but for most people, it probably isn’t.
And if we do have an economic depression which produces a 50% decline in the FTSE 100, it’s likely that the market would quickly recover, just as the S&P 500 did a few years after it hit rock bottom in 1932.
So while a US stock market crash does seem likely, and while that could lead to a proper 30%+ bear market in the UK, it’s also likely that any bear market would be both shorter and less severe than the average bear market.
Why the FTSE 100’s bull market could have a long way to go
Having looked at both sides of the argument I would say I’m a bull, but an open-minded bull.
I think it’s more likely that the market will go up over the next few years rather than down.
However, I also realise that we could easily have a bear market, although I think it’s likely that any bear market would be short and shallow.
I also realise that I could be wrong, but such is the nature of gazing into the future.
So if I had to make a definitive statement on this I would say:
The current FTSE 100 bull market is only a couple of years old and more likely than not has several years ahead of it. And unless the stock market doubles in the next few years, the next bear market is likely to be short and shallow.
But wise investors never make an all-in bet on one possible future. Instead, they invest to prosper no matter what the future brings (excluding nuclear war, asteroid strikes and nearby supernovas).
There has been two 20% ish “corrections” since 2009. I dont see why we cant get another 20%-ish one right now.
Im not sure that a definition of a bear market as a correction of >20% is useful. If the index falls 19% or 21% the difference is just as painful..,…
Hi carflap, yes 20% is of course arbitrary. I guess it’s a nice round number and coincides with some sort of pain threshold for many investors. I agree that we could easily get a 20%+ decline, but as I say it would probably be short and shallow because of the market’s already relatively low valuation.
As always an interesting and thought provoking article, which essentially follows on from your March report to subscribers, where you initially took a tongue in cheek approach to the recent decline but then acknowledged the more serious issues about how the media reports these types of situations. I get really frustrated that the FTSE 100 position is reported on a multiple daily basis; in the long run it is of no real significance and it just whips up media fury and scares people away from a very methodical method of gaining some real capital.
However, even for those of us who have been long term investors in the stock market, when the markets go through one of these gyrations it is slightly uncomfortable; I have been through so many, but each time, while easier as I have been there before, I still re-check my portfolio to make sure I have been sensible, which almost always I have and currently only down 7.5%, having withdrawn all dividends, apart from those that I keep in my SIPP as a buffer, as I follow a Natural Dividend strategy to provide an income at my stage of life.
Because Mr Market does what he does and the track record of the FTSE over the last 20 years, I am not an advocate of Passive investing in the UK; I think it works in the USA, but is probably one of the few markets that it really does, but unfortuantely most researchers base their evidence on the US market and apply it across all markets. Yes the UK market will get dragged which ever way by the US, and probaly most others, but I have been finding good returns in Japan for some of the other portfolios I manage that are at different stages of life to my own.
Do I think your estimate of what is going to happen to the market is right? I have no idea and as you readily admit, neither do you, but the statistics and evidence point to your guesstimate being correct, but only time will tell.
Hi Gareth, thanks for the excellent comments. I’ll respond to a few points in turn:
“I get really frustrated that the FTSE 100 position is reported on a multiple daily basis; in the long run it is of no real significance “
I completely agree. I’ve never understood why the daily news mentions that the footsie was up or down by a few points. What value does that have? It’s like calculating the average price of houses sold today and then mentioning how that changes from one day to the next. It would stir up emotions and provide absolutely no value whatsoever.
“when the markets go through one of these gyrations it is slightly uncomfortable”
This is why it’s so important that there’s a voice (not just mine, of course) for fundamental analysis, not just meaningless reporting on price movements. I think things are getting better, as CAPE is now widely used and it’s a very good measure of fundamental value, although far from perfect of course. But I think the uninformed still outnumber the informed ten to one, and probably always will.
So as politicians like to say, there is still much work to be done.
Interesting “exercise” John, thanks for that. Regarding S&P 500 or FTSE 100 I am always surprised by balancing: first 10% of the S&P 500 makes 50% weighting, first 30% of FTSE 100 makes almost 75% weighting.
Does it makes sense to make any kind of analysis based on these indices when you actually analyze “top ten” ?
Hi Robert, I agree, the cap-weighted nature of these indices is a problem. Some form of equal weighting (i.e. where constituent companies each make up an equal part of the index; 1% each in the case of the FTSE 100) is a good idea, but it involves more trading and is therefore more expensive to operate.
Whether index analysis is “useful” or “makes sense” is up for debate, but so many people (including me) pay attention to these indices that I do think it makes sense to analyse them, especially when the goal is to try to understand what sort of future returns they might generate over the next decade or so (although of course there will always be a healthy dose of uncertainty).
Thanks, John, I really enjoy your articles! I was brought here by Monevator and am just a vanilla indexer, but I still enjoy your analysis and deep dives into markets!
Glad to hear it WG.
I wish I’d read had access to this sort of info when I was a vanilla indexer in the 90s and early 2000s . It might have stopped me panic-selling at the bottom of the bear market in 2003!
Great article, as ever.
I can’t really understand what’s happened since 1999 for the index to still be around (approximately) 7000.
Do you know how the CAPE, P/E, dividend yield and dividend cover compares today versus the same measures taken in December 1999?
(NB I recognise that dividends still make the FTSE-100 a worthwhile investors).
Many thanks
Hi Jonathan, the past 20 years of zero price growth in the FTSE 100 is about the best example of valuation mean reversion I can think of.
At the end of 1999, the FTSE 100 produced earnings of 242 “index points” and a divided of 141 points.
Today, the FTSE 100’s earnings are 544 points and the dividend is 295 points.
So over those 18 years the index’s earnings and dividends have more than doubled, thanks to a combination of inflation and real economic growth.
However, from a price point of view the FTSE 100 has basically gone nowhere, as you point out. In 1999 and 2000 the FTSE 100 spent most of its time around 6,500 and it was at that level in late 2017 and is only about 5% above that level today.
The answer to this conundrum is valuation mean reversion.
In 1999, overoptimistic investors were willing to accept a dividend yield of just 2.1% because they thought the dividend would grow fast enough to make up for that weedy yield.
They were also willing to pay 32-times the index’s inflation adjusted ten-year average earnings, giving the FTSE 100 a CAPE ratio of 32.
Today, investors want a 4.2% yield because they think the dividend will go down or not grow quickly. And they’re only willing to pay about 15-times the index’s inflation adjusted average earnings, i.e. a CAPE ratio of 15.
So the dividend yield has doubled while the CAPE ratio has halved, which explains why the price has gone nowhere while earnings and dividends have doubled.
The good news is that today’s yield and CAPE ratio are attractive by historic standards, unlike in 1999 when they were extremely unattractive by historic standards.
The upshot is that, barring nuclear war or similar, it is almost inconceivable that the next 20 years for the FTSE 100 will be as bad as the last 20 years. Personally, I expect the index to more than double at some point in the next ten years, let alone the next 20, driven by inflation, economic growth and investor enthusiasm (which will return to the stock market at some point, perhaps when investors finally fall out of love with buy-to-let property).
Hi John,
Very interesting analysis on the FTSE 100. I agree that it seems fairly priced, if not relatively good value, based on the metrics you are using.
Have you considered the level of debt held by FTSE 100 companies? If we looked at the FTSE 100 as a single company, what would its debt be as a multiple of profit?
It strikes me that we have had a long period of “emergency-level” interest rates and a large number of companies have taking advantage of cheap debt. An increase in interest rates would reduce profits and stretch the current valuation of the FTSE.
Here is an attempt at a worked example:
Current FTSE 100 price: 7,000
Earnings: 500 (rounded, using earnings ratio of 14)
Debt: 3,000 (assuming ratio of 6, for illustration only)
Now let’s assume a 5% increase in interest rates which, after tax, hits profits by 4%:
Price: 7,000
Earnings: 380 [(500 – 120) – Current earnings less 4%*3,000]
P/E ratio: 18.4
I appreciate these numbers are made up and the increase in rates is a bit extreme (I don’t know either if debt being 6* earnings is realistic either). However, I would be interested to hear your thoughts.
Hi FD, that’s a good point and I think you’re largely right; many companies have taken on cheap debt in recent years, following a few years of deleveraging after the financial crisis.
I don’t have data on all the FTSE 100 companies, but if I restrict my stock screen to FTSE 100 stocks that aren’t banks or insurance companies (where “borrowings” either aren’t used or take a bit more legwork to calculate) then I’m left with 62 companies with a combined market cap of about £1.5 trillion.
That’s a significant majority of the index’s total market cap, so it should be representative.
The market cap-weighted “debt ratio” (total borrowings / 5yr average post-tax profits) is almost exactly six, so your assumed ratio of six was pretty much spot on.
This is not good, because my preferred max for defensive stocks is five, and most of those 62 stocks are not defensive.
So from 10,000 feet it looks as if there are lots of companies with relatively high and possibly imprudent amounts of debt, most likely because debt is cheap and debt is a useful way to boost growth when organic growth (rather than leveraged growth) is hard to come by.
I won’t bother speculating on what might happen if this or that interest rate is introduced, but I agree with your general point that interest rates are likely to go up, and that could hurt the index’s earnings in the short or even medium-term.
This is why I try to stick to under-leveraged companies where possible; because hopefully they’re more robust in the face of an uncertain future.
Crunching the same numbers for my “defensive value” portfolio, for example, gives a position size-weighted debt ratio of just over two, so comfortably less leveraged than the large cap index.
Hopefully that will translate into better performance during the next downturn, but the jury is out until the next downturn arrives.
Hi John,
I have just read your article and your analysis seems very relevant even now 7 months later. I would just like to ask you whether the enormous debts which all major economies have should be a cause of worry – and may lead to a potential bear market soon – how relevant is huge governments debts?
Hi Michael
I’m not an economist, so I’m not sure how relevant my opinion is! However, my gut reaction would be to say that there is only a weak link between government borrowing and the economy.
The main link that comes to mind is the cost of interest to the government, which will reduce public investment which may boost returns for private companies.
Also, high levels of government debt during good times makes it harder for the government to support the economy during recessions, e.g. through debt-fuelled public spending such as building more schools etc.
But in a ‘free’ economy where government spending is a small part of GDP, I think the effect would be limited.
The Economics Help website has a longer and better version of this sort of thinking.
So my position is that UK government debt won’t be a major factor in whether we see a bear market. More important factors are whether we have a recession (I have no idea) and whether current market valuations are excessive (in my opinion they are not).
I think we could well see a bear market soon, but I would be very surprised if it was anything like as bad as the dot-com and credit crunch bear markets because current market valuations are not remotely excessive (e.g. CAPE is close to ‘fair value’).