At the end of every year investment pundits love to write about their forecasts for the following year. For 2014 the consensus view was that the FTSE 100 would finally break through the 7,000 barrier.
It was and is an entirely reasonable target, but for one reason or another the index didn’t quite make it (although with almost two months to go it still might).
Personally I’m putting 2014 behind me and looking to the future. For most of my fellow pundits this will mean thinking about 2015 and whether or not the FTSE 100 will break 7,000, or perhaps even 8,000.
But I think looking to 2015 is too limited. The market might go up 10% or might go down 10%. Each is about as likely as tossing heads or tails.
The problem is that by looking at 2015 investors will be ignoring bigger questions such as, when could the FTSE 100 hit 10,000, or 20,000?
Such large numbers can appear ludicrous, and sometimes attract ridicule. But did you enter the stock market to gain 10%, or are you looking to double or quadruple your capital (or income) over the longer term?
If so then you need to be thinking about when the market might reach two or four times its current level.
Infinite growth on a finite planet
And that’s where the problems begin because at some point growth will stop. It’s as simple as that.
In the long-run there are obvious limits to exponential growth; to how many people there can be and how many goods and services they can consume on a single planet.
With this in mind I recently looked again at my FTSE 100 financial output data (i.e. its earnings and dividends) covering the past decade:
What struck me was the lack of growth in either earnings or dividends. Using an exponential trend line the earnings growth rate trend has been just 0.6% a year while dividends have a slightly faster growth trend at 2.6% a year. Averaging those two numbers gives a growth rate for the FTSE 100’s financial output of just 1.6% a year.
That sounds pretty weak, and it is.
CPI inflation over the same period has been 2.7% a year, so adjusted for inflation the economic output of the companies in the FTSE 100 has shrunk over the past decade.
Does this mean we’ve already hit the limits to growth? If that were the case then future returns from the FTSE 100 would be significantly reduced.
Looking for the signal in a noisy system
To answer that question we need to know if the last 10 years are indicative of a new long-term low-growth trend, or if it’s just a short-term blip, otherwise known as noise.
The critical factor we need to consider is timescale. In most systems the frequency of change due to noise is much higher than change due to a change in the underlying signal (the long-term growth trend in this case).
For example, the ratio between signal and noise frequencies on a telephone line may be 1,000 or more.
Or think of the global climate, where noise is the dominant factor over anything from a day to 20 years or so, and where the warming trend only becomes clear when you look at climate data over periods of 30 to 50 years or more.
To differentiate between noise and the underlying growth trend of the FTSE 100’s fundamentals we need to look at a longer period of time than just a single decade. So here’s all the data I have, which stretches back over more than 25 years:
In this chart, because of the longer time period, I’ve used a logarithmic vertical axis. That just means percentage changes at any point in time will look the same, so for example a 10% increase in earnings in 1990 will look the same as a 10% increase today.
Over this longer time period the underlying trend becomes a little clearer. I’ve added a couple of trend lines to show something approximating that trend.
During those 26 years earnings have been growing at about 6.4% a year and dividends at 4.5% a year. A reasonable estimate of the overall growth trend is 5.5% a year.
CPI inflation over this period has been 2.6% which leaves overall real growth at 2.9% a year.
If you look at the last decade’s relatively flat growth, it’s clear that growth has gone from above trend in the late 2000’s to below trend now. However, these differences are probably due to noise, i.e. short-term cyclical factors like booms and busts, as was the case with previous low-growth periods in the early 1990s and 2000s.
So while infinite growth on a finite planet is still impossible it doesn’t look like we’ve hit the buffers just yet, and in the longer term the FTSE 100 is likely to blow right past 7,000, and even 10,000, with relative ease.
Ken Brennan says
I concurr with what you have said here. I feel sometimes that the equity markets change too slowly for people. The DOW was flat in the 50s to 60s for a very long period and now it is much higher. I guess that we just have to be patient.
John Kingham says
Hi Ken, yes patience is the key. The very long-term growth trend, over a century or so, is between 1%-2%, if I remember correctly. A big problem in the 90’s was that the FTSE 100 went from 1,000 in 1983 (I think) to almost 7,000 in 1999.
That’s WAY ahead of trend which is largely why we’ve had zero growth, more or less, since then.
I guess that in 1999 investors thought another 7-fold increase in the following 20 years, i.e. from 7,000 to 49,000 by 2019, was achievable, which it clearly wasn’t.
We may get to 50,000 eventually, but it will take a lot longer than 20 years.
Well done for spotting this. This is a major concern for longer term investors, especially if the FTSE 100 continues to under performs inflation. At the start of the 10 year period the index was dominated by the financial sector which has clearly been through a major recession of its own making and with Banks now packed with low return reserves that growth will never re-surface. The index is still dominated by Financials, resource companies including oils and has companies like Glaxo & Vodafone which seem to be more interested in financial engineering rather than fundamental growth. Perhaps the FTSE 100 is not a good guide to what is happening in UK plc any more and you should look at the FTSE250?
John Kingham says
Hi Bob, I still think we can get back to inflation-beating growth in time, but growth may be slower than we’ve been used to, although that’s not necessarily a bad thing.
It may just be a fact of life and investors may start to look more for investments that can produce high cash returns today (which can be reinvested if they wish) rather than income and capital growth over the long-term.
The various crowd funding platforms do this quite well, allowing direct investment in companies or projects, so we may see more of that in future, but I still think traditional investing through the stock exchange has a long future ahead of it, it may just be a slightly slower growth future.
As for the FTSE 100 as a barometer of the UK, you’re right, the FTSE 250 is much better. The 100 is full of companies that have little or nothing to do with the UK economy, so its fundamentals are only partially relevant to what’s going on here.
Unfortunately though I haven’t yet built a dataset of FTSE 250 dividends and earnings going back any sort of decent amount of time. Perhaps that’s a project I can work on when I have some spare time.
What you have here is a low pass filter with a time delay. The problem is where to put the pass band, you don’t know what is signal and what is noise. You could be averaging out the next big thing and by the time your filter tells you about it another 25 years have gone by. Why PE10 and not PE5 or PE25.? You can use a business cycle to decide on say PE3-5 but nobody really knows if a business cycle is really 3-5 years. So PE10 is a guess in my view as the best compromise between filitering just enough of the higher frequencies to leave the information intact.
Its interesting to compare the chart with housing. The growth is better in stocks over a long period but volatility is less in real estate. Using leverage through a mortgage gives real estate back its edge but increases the volatility, so back to square one.
John Kingham says
That’s an interesting way of putting it and, having read up on what a “low pass filter with a time delay” is, I agree. And I also agree that the problem is deciding on what is signal and what is noise.
Actually I think that, because the economy is a complex dynamic system it’s all noise of different frequencies, but some noise is over such a long frequency that we can, with caution, treat it as a signal.
So for investors day to day events are clearly noise. The “business cycle” or short-term credit cycle of something under a decade may be more useful, but is very hard to predict. That’s why I looked at 25 years of data to filter out noise, although that’s all I have and I’d rather look at more.
For example if you look at the US data from Robert Shiller then the last century of real dividend and earnings growth is interesting because for the first 30 years (between 1914 and 1945) S&P 500 earnings and dividends fell in real terms. So even across an investment lifetime (approx. 30 years) you can have divergence from the underlying trend of economic growth.
Housing is kind of the same thing. It’s a real asset but there is no law of the universe that says house prices will go up in real terms either in the very long-run or over any 5, 10, 20 or whatever-year period. And of course they can’t go up faster than wages forever anyway because it’s wages that pay the mortgage.
As for PE10, it isn’t the best valuation tool for stable country indices. Research has shown that PE20 is better, and PE30 is better than that. But PE10 has stuck as a general rule of thumb and it’s fairly useful so I’m happy to stick with it.
Paul Hawkins says
Interesting article John. Out of interest where do you obtain your data?
John Kingham says
Hi Paul, my data is scraped from various places as nobody seems to have nice free data on the FTSE 100 available. So I have collected it from places like the FT:
http://markets.ft.com/research/Markets/Data-Archive (see the “download data” section).
And a few other places. Here’s a spreadsheet with some of the data:
Although that copy may be a bit out of date.
Interesting article – thanks.
According to The Daily Telegraph, the Governor of the Bank of England recently told a World Bank seminar that “the vast majority of reserves” of fossil fuels “are unburnable”, if the world is to avoid dangerous climate change.
In addition, the Rockefellers have recently announced divestment of a very large amount from the fossil fuel industry.
It seems to me that there are some questions here for investors:
1) Is it moral to invest in fossil fuels and other unsustainable industries?
2) Is it wise to invest in fossil fuel, given that they may be overvalued? Stock markets currently value them on the basis that they will be burned, but as noted, the Governor of the Bank of England says that they are unburnable if we are to avoid dangerous climate change.
3) What can small, cautious, investors do? Index trackers are a natural home for many cautious non-expert investors who want some exposure to equities. However, they do include substantial amounts in fossil fuels industries. There are a number of ‘sustainable’ funds out there, but do they entail risks / pitfalls for non-experts?
Any thoughts welcome, particularly on (3).
John Kingham says
Hi Chris, fossil fuels are something I’ve thought about quite a bit, on and off. My answers would be:
1) This is a complex topic. I don’t think there’s anything wrong with fossil fuel investment as such because society will need fossil fuels for at least another 100 years. The problem is when the companies profit at the expense of society by lobbying for pro-fossil fuel government policies, or muddying the public view of climate change. That’s the same as when tobacco companies were muddying the science on lung cancer (and I don’t think there’s anything wrong with investing in tobacco, as long as the companies are honest about the addictive and health damaging features of their products).
My preferred approach to these issues would be for long-term institutional investors (pension funds primarily) to lean on these sorts of issues, not as a moral issue, but as a way to maximise their very long-run returns, which is their fiduciary duty. Basically the economy will probably be bigger 100 years from now if we address climate change than if we don’t.
2) You’re talking about the Carbon Tracker “carbon bubble”. Personally I think valuation is more complex than that and that few investors base their decisions on the value of oil in the ground. It’s more about cash flows and so on in the shorter-term. I still have BP in my UKVI model portfolio and I haven’t changed my view on its valuation due to the carbon asset bubble, although I do think Carbon Tracker have produced a very helpful analysis.
3) I agree, picking “ethical” funds is no easier than traditional funds. Investors could look at something like http://www.yourethicalmoney.org/ but I’m certainly no expert on what’s available for ethical investors.
Thanks for the comments.
1) I think that we have the technology to move away from fossil fuels quite quickly; the question is whether the will is there. If we do continue to burn fossil fuels as you indicate, then widespread carbon capture and storage (CCS) will be essential.
I fully agree that long-term institutional investors should be using their influence.
2) Perhaps the value of Oil and Gas stocks depends on the viability of CCS. I must say it seems like a ‘sticking plaster’ solution to me. I think we would be very much better not producing greenhouse gas in the first place, rather than producing it, capturing it, pushing it down into the ground and hoping it stays there.
3) Thanks for the useful link. Quite a bit of research would be needed I think. There is a FTSE4Good tracker, but as far as I can see, this index includes substantial investments in Oil and Gas.
Nature has published a report on this topic. The results suggest that a third of oil reserves, half of gas reserves, and over 80% of current coal reserves should remain unused from 2010 to 2050.
To get a more complete picture it helps to look at total returns, i.e with dividends reinvested. On that measure the FTSE 100 is up over 60% since the start of the century.
Do not forget the power of compound interest on dividends. You all know the quote from Einstein.
John Kingham says
Hi Rob, yes but 60% in 15 years is an annualised growth rate of just 3.2% a year, which after inflation is probably something like 1% a year! Not exactly electrifying.
But the point of the article was more to get people thinking about what happens after 7,000, since the large-cap index has been floating around that number for so very long. In the longer-term we need to be looking to 10,000 and 20,000, and whether that’s even possible (without the helping hand of inflation of course).
There are two issues here:
1. FTSE 100 is not a relevant index / benchmark for me. My relevant benchmark is MSCI Word TR. As the later is more diversified, it has a higher expected return and should show a lower volatility over the long term.
2. I am a saver and a net stocks buyer. Myself I would like to see FTSE 100 breaching the 6,000 level not the 7,000. I like to buy cheap stocks, not expensive stuff.
For example I took the opportunity and in the last dip increased my portfolio 4 times in the last 6-7 weeks. I have started selling some of the stuff I bought, as some is a lot more expensive. For example today I sold 24% of my Tesco stock at 194p. I have me a tiny bit of profit around 1.5p per share, because I bought too many shares when they were very cheap and my average dropped to around 191p per share. I put another order for 203p for a third of what I have left, who knows in a few days I may get rid of some more Tesco again.
diy investor (uk) says
Well done on mention in This is Money article today http://www.thisismoney.co.uk/money/diyinvesting/article-2841233/MINOR-INVESTOR-FTSE-100-finally-crack-7-000-care.html
John Kingham says
Thanks John. I think that’s my first mention on a major mainstream website and it only took 6 years to get there!