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.
Interesting analysis. The S&P CAPE is now at 26.77 according to Robert Shiller’s website. This is well above its historical average and some commentators consider a correction/crash likely to happen in the next couple of years. If that happens, do you think the FTSE is also likely to fall (therefore touching very low CAPE values)? If this is the case, should the rational investor in UK shares beware of the risk of a fall in US shares even if the FTSE CAPE is relatively low?
Hi Federico,
Unfortunately the stock market is largely unpredictable, even at relatively high or low valuations. So just because the S&P CAPE is high doesn’t necessarily mean it will crash any time soon. However, if it did it would probably have some knock on effect for the FTSE. I don’t think FTSE investors have too much to fear from the expensive S&P though as FTSE valuations are currently good to reasonable, so if the FTSE falls they will only be more attractive to long-term investors.
I would say the only group with any concerns would be those who were looking to exit equities in the next few years, but those investors would do better to exit gradually as in the “glide path” rather than be looking to sell up all at once, precisely because of the risks associated with short-term market declines.
John, as always a thought-provoking post. Lovely to read someone who isn’t making random predictions about the next year, but refreshing to see a ten-year timeframe. We like long-term investing, not speculating on trades and short-term forecasts.
Cheers
Hi M, thanks. If us long-termers just keep plugging away we may just end up with a sensible mainstream media (although I very much doubt it).
My personal bugbear is the daily update on the FTSE 100. Exactly who needs to know that the market went up by 0.2% today? And if they need to know it surely they would get it from some sort of charting software or alert, not the mainstream media. It’s like saying house prices were down by 0.03% today… who cares! (and if somebody does care, they probably shouldn’t).
Hi John
As always an interesting insight into the vagaries of “The Market”. However, given the last 14 years in the UK and how the US market has gone recently, it will be interesting as to when the FTSE 100 breaks through the 7000 mark. It appears that the index is stuck in a rut and there appears to be a barrier which it seems impossible to break through; I have even heard fellow investors say that as the index approaches 6900 they sell out, so there seems to be a behavioural issue at work currently, which needs to be overcome before we break through this barrier.
Gareth
Hi Gareth,
I think you’re exactly right. However, predicting when that technical “resistance” will give way is virtually impossible. As long as total dividends from the market keep going up it will get better and better value at 7,000, and at some point yield chasers will push the market up regardless of how many short-term traders sell at 6,900.
This is related with how the index is constructed, for example an index with more components like FTSE 350 has already broken through the 2000 and 2008 maximums.
Hi Eugen, that’s an interesting point. I think it shows the power of people who are trading for “technical” reasons, i.e. selling the FTSE 100 (via ETFs for example) as it approaches it’s old high and therefore increasing supply and reducing the index’s level.
An index like the 350 is traded by a much smaller number of traders who therefore have much less impact on its overall level. Instead it’s driven more by fundamental investors who don’t care about charts (or at least don’t care as much).
That’s my guess anyway.
Technical trading does not necessarily keeps FTSE 100 under 7,000, there are other issues with the fundamentals of many of UK companies: banks, insurers, supermarkets, even farmas. If you check the S&P 500 you see there are many companies with technology links within it. These companies had a good time in the last 6 years. S&P 500 is a quite a cyclical index as well, in 2008 it went down by more than 50% but it recovered a lot faster. This compare with FTSE100 which is more defensive, there are higher diversification geographicaly, companies with activities all over the globe.
No index is perfect. Myself I use MSCI Word, as theoretically I could buy every stock available if I think there is value in this.
Re technical trading, I have heard a lot bad news as a result of the CHF volatility. Not only that Alpari gone in administration, but there were quite a few people who lost significant sums.
Hi Eugen, I agree that the fundamentals mean 7,000 is possible (i.e. the dividend yield isn’t 1% or 10% at that level, so the valuation is “reasonable”) but the exact figure of 7,000 is purely down to technical reasons. It is not a coincidence that the market peaked at almost 7,000 (a nice big round number) in 2000, 2007 and then again in 2014. The odds of that being a coincidence are negligible.
However, for long-term investors it should be nothing more than an interesting curiosity.