Once again the FTSE 100 has come eye-wateringly close to a new all-time high. By now this shouldn’t be big news because it’s been happening for almost all of 2014.
So what does it all mean? Is the FTSE 100 cheap, expensive, about to begin a massive bull run like the S&P 500 or enter a new bear market like it did in 2000 and 2007?
FTSE 100 price charts seem to suggest a massive bear market is looming
Have a look at the price chart below and you’ll see a price pattern which is hard to ignore:
If you’re like most people your brain will immediately tell you that the market has swung between approximately 3,600 and 6,800. It takes 4 or 5 years to climb up and then 2 or 3 years to fall back down again.
There appears to be some form of invisible resistance above 6,800, or thereabouts, which stops the market climbing higher. On the other hand an invisible support seems to lurk below 3,600, stopping the market from falling any further.
This pattern is virtually unmissable. But it’s also irrelevant. In fact it’s worse than irrelevant, it’s misleading.
Focusing on price history alone is like focusing on the price history of a house without knowing anything about the house itself.
Perhaps someone bought a house for £100,000 a decade ago and today they sold it to someone else for £200,000. What does that tell you about the sort of price rise the new owner could expect in the next 10 years or so? It tells you nothing.
For that you’d need to know what sort of house it was, where it was, what sort of rent it could rent it could command as a buy-to-let investment and many other factors.
Price is simply the amount that somebody else was willing to pay for an asset at some point in the past. Without some information about the underlying asset it is pointless to try to infer things about the future from past prices alone.
In the long run prices follow profits
What matters is not whether or not the price is high relative to past prices, or whether we’re at a new high, but whether price is high relative to the factors that drive price, and the primary driver of price in the long-run, for both stocks and property, is earnings.
If we take a look at the cyclically adjusted earnings of the FTSE 100 as a whole (i.e. the 10 year average of inflation adjusted earnings) then we can see another pattern. This time it isn’t one that bounces up and down between two points like the price pattern, but is instead a pattern of steady, progressive growth.
The FTSE 100 price level uses the left axis while its cyclically adjusted or “smoothed” earnings are on the right.
The axis for the price level is set at 16 times that of the smoothed earnings because, over the long-term, investors have been willing to pay approximately 15 times the index’s smoothed earnings. This multiple is the well-known CAPE (cyclically adjusted PE) ratio from Robert Shiller.
The three most important words in investing are valuation, valuation, valuation
As you can see in that chart above, the FTSE 100’s price has been fairly close to 16 times its cyclically adjusted earnings in most years. When it has moved far above that level, as it did at the end of the last century, returns going forward have been less than generous. On the other hand when the multiple has been far below 16, as it was in the crisis year of 2009, returns have been much higher.
This is a general pattern that we see in markets around the world; that they hover around some central average CAPE figure, which for most markets most of the time is something like 15 or 16.
This isn’t a rule or law of physics, but it’s been a reliable guide for more than a century, so it definitely has some validity as a practical rule of thumb.
What it isn’t though is a guide to where the market will be this year or next (or the year after that, or even the year after that). The market is too efficient and random for that and one person’s guess is as good as another.
What we can say though is that there are certain long-term trends where it’s reasonable to assume that they continue:
- Inflation – It’s reasonable to assume that we have inflation at perhaps 2% a year for the foreseeable future.
- Real growth of profits (and dividends) – Another trend is real (after inflation) growth in corporate earnings and dividends. This also has a long-run historic average of around 2% a year.
- Valuation mean reversion – The final trend is that over time CAPE has an average value of 15 or 16, and so that’s a reasonable best guess for the market’s valuation multiple 10 years from now.
If the market’s CAPE is below average today then we’ll have a tail-wind as CAPE increase back to its average. That will drive the market upwards faster than the growth in underlying earnings. If the FTSE 100’s CAPE is above average then that same mean reversion becomes a head-wind and the market’s price will increase more slowly than earnings.
So what does all this talk of valuation multiples and CAPE have to do with the market bouncing between 3,600 and 6,800, and why does it mean that a fall back to 3,600 is unlikely, even though we’re at near record highs?
If you look at the second chart you can see that in 2000 the price was way above the earnings line. In other words CAPE was well above 16; in fact it was nearer 32. Again in 2007 the price was above the earnings line and so above a valuation multiple of 16; this time it was priced at 20 times smoothed earnings.
Today, even though the price is at the same level as those two prior peaks, corporate earnings and dividends have continued to increase and so now the price is below that earnings line. CAPE is now just 13.3 and comfortably below its long-run average.
The FTSE 100 is now back to where it was in 2000, but the earnings of the underlying companies have more than doubled in that time making today’s price quite reasonable in valuation terms. That’s why it’s so important to not just look at the market’s price, but to take into account the productive output of the underlying asset that you’re investing in, i.e. the earnings, dividends and so on.
Decent future returns is a reasonable expectation, despite the FTSE 100’s near-record level
Today the total of the FTSE 100’s cyclically adjusted earnings are equivalent to approximately 515 index points. Each index point is worth about £250 million, so very approximately those 100 companies have earned an inflation adjusted, combined average of £131 billion per year.
If we assume that the earnings of those 100 companies grows at a historically normal rate which is 2% faster than inflation, which also runs at 2%, then in 2024 those earnings will have reached 760 index points (about £194 billion per year).
Apply to those earnings the average CAPE multiple of 16, an amount which investors have typically been willing to pay to buy those earnings, and you end up with a FTSE 100 value of just over 12,000 in 2024. I won’t try to be any more accurate than the nearest thousand because it’s impossible to be precise about the future of the market.
So in the short-term it’s impossible to tell where the market is going, but in the longer-term we can see what sort of range of values would be reasonable, and 12,000 is currently my “central projection” for the FTSE 100 a decade from now, which is the sort of timespan a long-term investor should be concerned about.
I’ll leave you with my FTSE 100 “heat map” which shows the range 10-year future returns implied by various market valuation levels over the last 25 years. It also shows what the FTSE 100 actually was at the time. If the market was in the red then the implication was that future returns would be bleak, yellow implies average returns and green implies good returns.
Today the FTSE 100 sits in the light green band, with projected future real returns of 6% to 8% per year over the next decade with dividends reinvested (or 8% to 10% if you include inflation at 2%).