Unfortunately most of the investment media focus on the daily movements of the FTSE 100. While this makes a nice soundbite at the end of a news feed, it has about as much use for investors as a chocolate fireguard. Instead, investors should focus on where we are now in the valuation cycle.
Smart investors have long-known that the current PE ratio is a poor indicator of value. Instead, it is better to “cyclically adjust” the earnings by averaging them over a decade or more. This idea goes back at least to the 1930s, and may go back many centuries more.
A simple but powerful idea
The idea is simple. Over time the price of an asset (whether it’s a share, a house or something else) will move up and down depending on demand from investors. But prices are anchored to future incomes, whether dividends from shares, or rental income or mortgage costs on a house.
Data is available on the S&P 500 index going back over a century and it shows that the American index’s current price has averaged about 16 times the cyclically adjusted earnings of its constituent companies.
When demand is low from investors, such as during recessions or depressions, valuations fall. At their lowest points they can fall below half their long-run average. In contrast when investors are jubilant and expect trees (and stock prices) to grow to the moon, they pay a far higher price, perhaps two or three times the long-run average.
Although we don’t have data for the UK going back a century, we do have a quarter century of data which I will gladly share with you in the chart below:
FTSE 100 Valuations – 1988 to 2013
The main points to note are:
- The black line is the FTSE 100 using monthly data
- The scale on the left is logarithmic, so that each step upwards doubles in value. This means steady growth produces a straight line on the chart rather than an exponential curve upwards. It also means that a 10% move in the value of the FTSE 100 in 1988 will be the same size as a 10% move in 2008 (for example)
- The green bands represent CAPE values (Cyclically Adjusted PE), which are the basis for the valuations
- The UK average CAPE is assumed to be 16
- The steady upward slope of the green bands shows how the UK and global corporate earnings have grown through this period (in nominal terms, although they have grown after adjusting for inflation too)
The valuation bands run from half the assumed average of 16 right up to about double that value. This range encapsulates the vast majority of peaks and troughs, both in the US and the UK. Some markets are different and have different average valuations (Japan’s median CAPE of the past 30 years is more than 40!) but the same principle applies.
FTSE 100 still “slightly cheap”
The current value of the FTSE 100 in the chart above is 6,621. This is close to the all-time high in terms of index points, but in terms of valuation it is below average. That means future returns may be slightly above normal (across a range of time periods), but not by much, and normal means something in the region of inflation plus 5 percent.
Where to next?
Sadly my crystal ball is broken, and particularly so at the moment. With valuations at middling, almost “normal” levels it is impossible to say what will happen. But that’s okay because most of the time that’s true. The market is only mildly predictable at extreme valuations, and isn’t predictable at all at other times.
But if I must don my prognosticators hat, then the chart implies that anything under 5,000 is an absolute bargain, up to 8,000 is reasonable, while 10,000 is pushing it a bit. If we get to 14,000 in the next few years, just remember that it’s a long way down from the top…