For my 2015 FTSE 100 forecast I thought I would bend over backwards even more than usual to highlight just how uncertain the future really is, and how pointless most forecasts are (especially those that pick a single figure like 7,500 as a target for the end of the year).
Forecasting the FTSE 100 over the long-term
For a start, I won’t be picking a single figure as my guess (as that’s all they ever can be) for where the FTSE 100 will be at the end of the year. In fact, I won’t be making any forecast for where the market will be at the end of this year at all.
Instead I will take a more realistic approach and simply point out the range of values that we could reasonably expect the market to reach by 2025.
Why “forecast” all the way out to 2025? Because I think a 10 year forecast is more useful for investors than looking just one year ahead. That’s true whether the investment is a buy-to-let flat or a FTSE 100 company.
Assumption 1: Real earnings and dividend growth at 2%
My first assumption for forecasting the FTSE 100 out to 2025 will be that total earnings and dividends for the largest 100 companies will grow about 2% faster than inflation each year.
Historically that’s quite conservative, and given that nobody really knows how those companies will grow in the future it makes sense to be conservative.
Assumption 2: The FTSE 100’s CAPE valuation will follow historic norms
Equity markets are typically valued in terms of price relative to earnings, in other words the good old PE ratio. However a better approach is to use CAPE, the Cyclically Adjusted PE ratio.
CAPE uses 10-year inflation adjusted earnings instead of current earnings because averaged or “smoothed” earnings provide a much more stable figure against which to compare today’s price, which in turn makes CAPE a much better predictor of the future than the standard PE.
Today, with a market value of 6,400, the FTSE 100 has a CAPE ratio of just under 12, and its average real earnings over the past 10 years have been 537 index points (it’s easier to work with index points rather than trying to convert index points into pounds, although that is possible).
Assuming 2% real growth and 2% inflation gives a cyclically adjusted earnings figure of almost 800 by the year 2025, and that’s the figure I’ll use to work out where the FTSE 100 might be 10 years from now.
To convert that cyclically adjusted earnings figure into a FTSE forecast it’s important to realise that equity markets tend to have CAPE valuations which are centred around the mid-teens. However, occasionally they can go much higher or lower.
In the US for example, the S&P 500 has a 100-year mean CAPE value of 16.5 and a median value of 15.3, but also a minimum of 4.8 and a maximum of 44.2.
Another important point is that, in general, CAPE is more likely to be close to its central value of 16 or so rather than at the extremes of perhaps double or half that value.
And because it’s more likely to be near its average value it’s also more likely to fall when valuations are high, and climb when valuations are low. This is exactly why it’s usually a good idea to buy shares at low valuations and sell them at high valuations.
2015 to 2025 – (Probably) a good period for investors
If we combine those two assumptions, of 2% real growth for the FTSE 100 companies as a whole and a probable range of CAPE valuations which is historically normal, the following results appear:
Note: The range of values and their associated probabilities are both taken from the last 100 years of data for the S&P 500 because data for the FTSE 100 only goes back 30 years or so. The two indices have had broadly similar valuation ranges over those 30 years.
The orange row indicates that the FTSE 100’s current CAPE valuation of 12 puts it in the “slightly cheap” category, and that a historically “normal” CAPE valuation of between 14 and 20 would put the market somewhere between 7,400 and 10,600 today.
If the market remains “slightly cheap” by 2025 it will be somewhere between 9,400 and 11,000 (under the previously stated assumptions), but if valuations increase back towards “normal” levels then the market could reach as high as 11,000 to 15,700.
On the other hand, if investors are pessimistic and fearful in 2025 then valuations will probably be very low. The market might only have a “very cheap” CAPE valuation which means a market value of between 6,300 and 7,900. Not a particularly good outcome 25 years after the dot-com bubble, but not entirely unlikely either.
However, if investors are optimistic and greedy in 2025 then that would lead to higher valuations, just as we had in the boom of the late 90s. If that were the case then a market value of more than 22,000, or three times the FTSE 100’s current level, might be easily achievable.
At that point investors would be very happy, but future prospects for the market would be just as bad as they turned out to be in 2000.
No precision, no certainty and no crystal balls
As you can see there are no easy answers when it comes to forecasting the future. I could easily say that I think the FTSE 100 will reach 7,800 by the end of 2015, but such predictions are about as much use as a chocolate fireguard.
Hopefully what I’ve shown here is a more realistic picture, with the current value of the FTSE 100 shown in the wider context of the range and probability of values it could reach in the years ahead.
If only someone would apply those ideas to the UK housing market; it would certainly raise some eyebrows about the sustainability of today’s property valuations.