Last Updated July 21, 2015
Now that the FTSE 100 has broken through the 7,000 barrier investors can finally set their sights on something more interesting: The big 10,000.
Obviously this isn’t going to happen overnight. From where the FTSE 100 is today it would take a 43% gain to reach that giant milestone and you just don’t get gains like that in a year or two unless the market is coming out of a bear market bottom, which it isn’t.
On the other hand we could see another bear market if the global economy starts to deteriorate, or if something else gives investors the jitters.
So which is more likely in the next 5 years: A bull market to 10,000 or a bear market to 5,000?
Forecasting the FTSE 100 using charts
Using price charts is a popular way to get a feel for where an index or a company’s share price might go in the short and medium-term. While I don’t use charting techniques myself, I think there is definitely some merit to it.
You only have to look at the chart below from Google Finance showing the FTSE 100 over the past 15 years to see that:
There is a clear pattern where the FTSE 100 bounces back and forth between 3,500 and 7,000, up and down and up and down and finally up again to around 7,000 today.
With that pattern in place, if I ask my 5-year old son which way the line will go next I can pretty much guess he’ll say “down”.
So from a charting point of view (or at least my point of view as a non-chartist) the market is more likely to fall to 5,000 than soar away to 10,000.
In fact the chart hints that we might even see 3,500 for the fourth time in 20 years. How depressing is that?
But that isn’t the end of the story. There are other ways to forecast which way the FTSE 100 will go and my preferred approach paints a very different picture.
Forecasting the FTSE 100 using its dividend yield
One way to think about whether 5,000 or 10,000 is more likely in the next 5 years is to think about how those levels would affect the FTSE 100’s dividend yield.
The first thing we need to do is look at how the FTSE 100’s yield has changed over the years so that we can guesstimate what a “typical” or “normal” range of values is.
Since 1985 the yield has almost always been between 3% and 4%, apart from during the dot-com mania of the late 1990s where it fell to almost 2% and the depths of the financial crisis in 2008/9 where it climbed above 4% for a short while.
I should point out that the chart is based on a snapshot of the yield at the end of each year, and so for example the market’s dividend yield actually reached more than 5.5% at the bear market bottom in March 2009.
However the data in that chart is more than good enough for this thought experiment. The FTSE 100’s yield is almost always between 3% and 4% and any value outside of that is usually short lived.
Yesterday the index stood at 6,950 with a dividend yield of 3.42% (according to the FT’s Data Archive and “World markets at a glance” report). That means the dividend was 238 in terms of whole index points.
If the FTSE 100 collapsed to 5,000 tomorrow it would end up with a dividend yield of 4.8%, which is well outside the “normal” range. The implication is that 5,000 is unlikely at the moment, at least from a dividend yield point of view.
Going the other way, if the market shot up tomorrow to 10,000 the dividend yield would drop to 2.4%, which is also outside the “normal” range. Again, 10,000 is an unlikely value based on the size of the current dividend.
So they’re both unlikely, but which is the more likely of the two at the moment?
Looking at the dividend yield chart it seems to me that a 2.4% dividend yield is more likely than a 4.8% yield (which isn’t even on the chart), so right now I would say that 10,000 is the more likely figure in the short-term.
For a 5-year forecast I’ll have to make a couple of assumptions about:
- Inflation – I’ll assume this runs at 2%
- Real dividend growth – I’ll assume the FTSE 100 dividend grows 1% faster than inflation
Combining those two assumptions gives a baseline nominal dividend growth rate of 3%. I don’t think that’s particularly optimistic and is in fact slower than the historic average.
So with those assumptions in mind, the table below shows how the dividend would grow and how the dividend yield would change with the FTSE 100 at either 5,000 or 10,000 (and I’ve included 7,000 as well so you can see what might happen if the market stays where it is today).
|Year||Dividend||Yield at 5,000||Yield at 7,000||Yield at 10,000|
As the market’s dividend grows each year the yield at each price level goes up as well, of course.
So if we’re unlikely to see the FTSE 100 at 5,000 today, because that produces a dividend yield of 4.8% which is outside the “normal” range, then by 2020 it becomes incredibly unlikely that we’ll ever see the market at 5,000 again.
Economic growth and inflation combine to push the dividend up to the point where we’d have a 5.5% yield at 5,000, which is just not conceivable outside of a major crash.
But over time the 10,000 level becomes more and more realistic, just as the FTSE 100 at 7,000 has over the past decade. By 2020 the index at 10,000 could have a dividend yield of 2.8%, which is only very slightly outside the normal range.
Looking at the dividend yield chart above, the 2.8% level was either reached or breached by the end of 1986, 1993, through the whole of 1996 to 2001, and then again in 2006 and 2010.
So a 2.8% yield is not spectacularly low, which means that 10,000 is an entirely reasonable possibility by the year 2020.
Of course the FTSE 100 may not reach 10,000 by 2020, but if it doesn’t that’s not necessarily a bad thing.
Even if the market stays at 7,000 until the end of the decade, investors are likely to receive higher yields as the years go by. That means they get a better income or more dividends to reinvest, and either way that sounds like a win/win situation to me.