On Wednesday the FTSE 100 closed just above 6301 points, continuing a near-20 year tradition of failing to get much above that level.
For some investors that’s depressing news; after all an investment going nowhere for 20 years is not exactly a stunning success.
But for investors who are thinking about returns over the next 20 years rather than the last 20 years, this lengthy sideways market is in fact better news than it might at first appear.
Sideways markets usually lead to cheaper markets
The chart below shows the basic story:
The last 20 years can be split into two main parts:
1) Party Time – Where investors thought the economy was going to grow massively, thanks to the internet and the World Wide Web.
2) The Hangover – Where investors realised that the FTSE 100’s profits and dividends were in no way sufficient to justify its dot-com peak of 7,000 and so the market collapsed. An unwillingness to relinquish the dream of 20% per annum growth led to the 2003-2009 credit-driven boom and bust and then the 2009-2016 stimulation-driven boom and bust.
If humans were rational (which they’re not, either individually or in groups) then the FTSE 100’s price history would look something like the blue “Rational Path”.
That Rational Path shows the market price increasing gradually, in line with the gradual increase in average profits and dividends generated by the 100 companies which make up the FTSE 100.
But humans are not rational and so rather than a smooth increase in market value we saw multiple greed-driven bubbles followed by multiple fear-driven crashes.
However, after 20 years of steady growth the FTSE 100’s long-term average profits and dividends have increased to the point where today’s FTSE 100 value of 6,300 is not only not expensive, but is instead positively cheap.
Growth, mean reversion and fair value
Trees do not grow to the sky and neither do stock market prices (or house prices for that matter).
In the long-run trees, stock markets and house prices vary around some long-term average. In the case of stock markets and house prices that average is the price to earnings ratio.
In the specific case of equity indices like the FTSE 100, my ratio of choice is the cyclically adjusted PE ratio (CAPE), which is the ratio between the current index price and its ten-year inflation-adjusted average earnings.
The long-term average CAPE ratio for the FTSE 100 and most other major indices is somewhere in the mid-teens (16 is a commonly used figure).
Today the FTSE 100’s CAPE ratio is 12.2, which is of course well below that average of 16.
That’s fairly normal though because most of the time the FTSE 100’s CAPE is above or below average rather than exactly on it, largely because investors are usually either somewhat optimistic or somewhat pessimistic.
So where are we today in terms of historic norms?
Have a look at the chart below, which shows how the FTSE 100’s CAPE ratio has varied relative to its long-run average over the last 30 years or so.
It covers the lead up to the dot-com bubble, through to the near-depression of the great financial crisis and finally on to where we are today.
You can think of the yellow line in the middle of the rainbow as a more accurate version of the Rational Path shown in the previous FTSE 100 price chart.
As the index’s price moves into the red or green zones it departs from rational pricing and moves further into the world of emotionally driven pricing.
In other words, in a rational world:
- In 1999 the FTSE 100 “should” have been at 3,300 rather than 7,000
- In 2007 the FTSE 100 “should” have been at 5,500 rather than 6,500
- Today, the FTSE 100 “should” be at 8,300 rather than 6,300
If the FTSE 100 were “rationally” priced today at 8,300 it would have a dividend yield of 3% rather than its current 4%, and 3% is an entirely normal yield and not excessively low by any stretch of the imagination (unlike in 1999 when the yield was about 2%).
Since the market is currently below fair value I expect returns over the next five, ten or 20 years to be somewhat better than usual, i.e. better than about 7% per year, which is the long-run average rate of return on UK equities.
However, if future returns are likely to be better than usual, why don’t investors pile into the FTSE 100 and drive the price up to where the current price and future expected returns are “normal”?
There is always a reason, and the reason is usually either fear or greed. In this case it’s fear.
An uncovered dividend is holding the FTSE 100 back
There are a million and one reasons why investors would be fearful; the impending Brexit referendum chief among them.
But there is another problem: For the first time in at least 30 years the FTSE 100’s dividend is not covered by its earnings.
As you might have guessed, an uncovered dividend is not good. Unless those earnings recover fairly quickly there is a very good chance that the FTSE 100’s dividend will decline over the next year or so.
I suspect that this risk of a falling dividend, combined with a high PE ratio which comes from having very low current earnings (the standard one-year PE ratio for the FTSE 100 is currently above 30), is keeping the market closer to 6,300 than 8,300.
As always, how this situation will be resolved is unknowable, but:
One way or another the FTSE 100’s CAPE ratio will revert back to its historic average of 16; of that I have no doubt.
It will happen either because the FTSE 100’s price goes up or because its earnings stay low for several years, dragging down its cyclically adjusted earnings.
History suggests the former, and if that suggestion is right then the FTSE 100 today is much better value than it has been throughout most of the past 30 years.