Last Updated July 21, 2015
I’ve written a lot recently about the FTSE 100, whether it’s expensive or cheap and different ways of visualising the range of values it could reasonably reach; so when a friend of a reader suggested that my valuation “bands” were too wide, I decided to review my approach.
If you look back at some of my recent articles on FTSE 100 valuations, you’ll find my CAPE Probability Fan Chart and Valuation Heat Map (CAPE is Robert Shiller’s valuation tool, the Cyclically Adjusted PE ratio).
In both of those charts I use a range of bands covering CAPE valuations from 8 to 32. The general idea is that the FTSE 100’s CAPE valuation generally moves in a range from half to double its long-term average value (which is about 16).
In the latest UK Value Investor newsletter I labelled these valuation bands from “Very Expensive” to “Very Cheap” as you can see below:
And these are the bands that are accused of being too wide. So the question is, are they?
Too wide, or poorly defined?
Having looked at this for a while, I don’t think the bands are too wide. In fact I think they may be too narrow, but even that isn’t the real problem. The real problem is that the boundaries between one band and another are arbitrary, or worse, they are based on an irrelevant idea; the idea that they should be evenly spread.
Given that the bottom half of the range runs from a CAPE of 8 to 16, it seemed reasonable to split that half into four groups, each with a range of 2 (8-10, 10-12, 12-14, 14-16). And the upper half of the full range goes from 16 to 32, so do the same there and you end up with another four groups (16-20, 20-24, 24-28, 28-32).
I think those groups look nice, they’re balanced but they’re also meaningless.
Cheap and expensive relate to expected future returns
When people talk about “cheap” and “expensive” investments they are usually implicitly talking about expected future returns. If something is cheap but expected returns are normal then it isn’t really cheap; it’s fairly valued.
So what happens if I organise these valuation bands based on expected future returns? A market with high expected future returns could then be sensibly labelled as “cheap”, and one with low expected future returns could be called “expensive”.
Future returns can be estimated by assuming that cyclically adjusted earnings (their 10 year inflation adjusted average) will grow in line with inflation plus 2% (i.e. 4% a year in total), which is about the long-run average growth rate.
I’ll assume that the median CAPE value is 16, so that’s our “fair value”, and the market will have that valuation in 7 years (the typical time required for mean reversion, according to Jeremy Grantham’s GMO). So over 7 years (according to this model) the FTSE 100 will produce capital gains of 4% a year plus or minus whatever gain or loss is required to get its valuation back to a CAPE of 16.
From fair value the long-run average real return from UK shares is 5% a year (2% real growth plus 3% from dividends). If the market is high enough so that the 7-year annual returns are half that amount (i.e. 2.5% a year) then I’ll call the market Slightly Expensive, and if 7-year real returns are expected to be negative then I’ll call that Very Expensive.
On the other hand if the market is low enough so that 7-year real returns are 50% above normal (i.e. above 7.5% a year) then I’ll call that Slightly Cheap, and if those real returns are expected to be more than double the long-run average (i.e. above 10% a year) then I’ll call the market Very Cheap.
Of course those are arbitrary and subjective definitions, but they seem reasonable to me.
The table below shows what sort of FTSE 100 level we would have today if future returns were as outlined above:
The current valuation band is highlighted.
With this approach any extreme valuations like the dot-com bubble with a CAPE of 32 just get lumped into “Very Expensive”, which seems fair enough as I can then quantify the level of expensiveness by measuring the exact expected 7-year return (in case you’re interested, the expected 7-year real return from 1999 was minus 6% a year; not what I’d call an attractive proposition).
Here’s what those bands look like using my traffic light colour-coded “heat map”:
The top of the red band is the all time high valuation of CAPE 32 from 1999, while the bottom of the green band is the lowest CAPE of 10, from 2009.
Currently the FTSE 100 is at 6,680, so that puts it in the “Slightly Cheap” band with 7-year expected real returns of 8.2% a year (10.2% if you include inflation at 2%). So although this bull market has come a long way from the dark days of 2009, it may have plenty of wind left in it.