The FTSE 100 closed last Friday at 5,129, about 13% down from when the carnage began in early August. At that level it has a PE10 of about 12 (PE10 is the 10 year average real price to earnings ratio) while the PE10 average is around 17.6. PE10 has been a pretty good indicator of future returns over the last century and it’s a favourite of mine for checking what sort of returns might be possible in the next few years.
Shares were cheap at 6,000 and now they’re even cheaper
I have a rule of thumb which says the index is almost always between half or double its average PE10. By my calculations that average is currently 17.6, so the FTSE 100 should be somewhere between about 9 and 36 times the 10 year earnings average. This gives a range for the index today of between 3,800 and 15,300, with a normal level of about 7,600.
The closer the index gets to the extreme levels, the more likely it is that it will head back the other way and there is over a century of data which backs this up. Since the index is currently well under the normal level of 7,600, long term returns from here are likely to be better than average.
If that’s the case, why are investors panicking?
These should be happy times for value investors, not sad times; but what has struck me most about the recent falls is the level of panic from investors who should know better.
As much as we all hate to see the value of our portfolios go down, is there really any new news in the past month that makes so much difference? Wasn’t it obvious that these debt issues were here to stay and that this great repression (a term coined I believe by Niall Ferguson) would last a good many years yet? Apparently not.
So what has changed in the last few weeks? As far as I can see, the only thing that changed was the short term investor’s opinion of what the next year or two might look like. Since short term investors drive the market in the short term, changes in their sentiment can have dramatic effects on the value of shares. Now that they’ve changed their mind from a ‘V’ or short ‘U’ recovery to a long ‘U’ recovery, they’re selling shares and buying gold in a clamour for ‘safety’.
In contrast, for the real long term investor, nothing has changed. The same future lies ahead and it is still just as unknown as it was a month ago and a year ago. No more, no less.
Market timing has a terrible history as an investment strategy and if you’re trying to second guess what’s around the corner and position your portfolio accordingly, market timing is what you’re doing. Market timing makes total sense; the problem is that only a tiny number of people have the ability to connect the dots well enough to make money out of it. Almost everyone else is better off doing something else.
An alternative course of action
A selective value investor, for example, would keep their eyes on the horizon and not the floor in front of them. They would look for companies that are likely to survive most things short of nuclear war, and they would just keep buying them when they’re cheap and selling them when they’re not so cheap. The fact that the unpleasant unknowns – which are always lurking in the future – had finally arrived, would make not one jot of difference.Nobody knows what’s going to happen to the economy tomorrow, next year or in 5 years’ time. All you do know is that at some point things will look fantastic and everybody will be happy. Then, at some later point, things will look terrible and everybody will be unhappy. As a value investor, you should know what to do and it’s summed up in the idea of being “greedy when others are fearful and fearful when others are greedy”.
I’ll end on another couple of quotes from that most quotable Mr Buffett. First, on worrying about the economy:
If we find a company we like, the level of the market will not really impact our decisions. We will decide company by company. We spend essentially no time thinking about macroeconomic factors. In other words, if somebody handed us a prediction by the most revered intellectual on the subject, with figures for unemployment or interest rates, or whatever it might be for the next two years, we would not pay any attention to it. We simply try to focus on businesses that we think we understand and where we like the price and management. If we see anything that relates to what’s going to happen in Congress, we don’t even read it. We just don’t think it’s helpful to have a view on these matters.
And when asked how he felt about the bear market in 1974, a few years before equities were supposedly dead:
[I feel] like an oversexed guy in a harem, this is the time to start investing.