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).