In December 2015 I wrote the first of what will hopefully be a very long series of annual forecasts for the FTSE 100, FTSE 250, S&P 500 and UK housing market.
That first article forecast the value of the FTSE 100 at the end of the 2016 and – miracle of miracles –was just about spot on.
Here are the gritty details:
- In late 2015 the FTSE 100 stood at 6,061
- My forecast of “fair value” for the end of 2016 was 8,272
- My forecast of “expected value” for the end of 2016 was 7,100
- The FTSE 100’s actual value at the end of 2016 was 7,120
The fact that my forecast was within 0.3% of the actual result is of course mostly down to luck; unfortunately the future is just not that predictable.
However, it wasn’t all luck and I do think my forecasting method is fundamentally sound, although of course there’s always room for improvement.
Most of the investment forecasts I’ve read are of the “I think such-and-such will happen” variety, which is definitely not how I approach the task. Instead my approach is based on facts and figures and long-running historic norms rather than speculative flights of fancy.
If you’re interested, I’ve worked through my forecasting method in some detail below. If you’re not, then skip to the bottom to see what the future (possibly) holds.
This forecast is based on the cyclically adjusted PE ratio (CAPE)
The CAPE ratio is my standard measure of value for stock markets and so it makes sense to base my forecasts of future stock market values on that ratio as well.
The basic steps of are to forecast:
- Inflation: For this I use the latest Bank of England inflation report
- FTSE 100 earnings: I assume next year’s earnings will equal the average real earnings over the previous decade
- Cyclically adjusted earnings: This is the FTSE 100’s ten-year real average earnings up to the end of 2017 (i.e. including the earnings calculated in step 2)
- Fair value: I assume fair value occurs when the FTSE 100’s CAPE ratio equals its long-run average, which I take to be 16.
- Expected value: I assume the expected CAPE ratio a year from now is halfway between the FTSE 100’s current CAPE ratio and its fair CAPE ratio.
Okay, let’s dive in and work through each of those five steps in turn.
Forecasting inflation for 2017
The inflation “fan chart” from the Bank of England’s latest inflation report shows that the BoE’s central forecast for inflation in 2017 is slightly over 2%. I’ll be a bit cautious and take 2% as my inflation number.
- 2017 inflation forecast = 2%
Forecasting FTSE 100 earnings for 2017
The FTSE 100’s average real earnings over the last decade came to 484 index points, and that’s basically my forecast for 2017’s earnings. However, that number has to be adjusted upwards for inflation over the next year, so:
- 2017 earnings forecast = 484 + (484 * 2%) = 493 index points
Just to give you an idea of how that compares to last year, 2016’s earnings at the end of the year were 212 index points. That’s actually an incredibly depressed level of earnings, caused largely by huge declines in resource and energy-related company profits (two sectors which the FTSE 100 is weighted towards).
So my forecast is based on a doubling of profits over the next year. That may seem optimistic, but really it’s just forecasting a return to normality from currently depressed profits.
Forecasting cyclically adjusted earnings for 2017
We now have one-year earnings for 2017, so to get the cyclically adjusted (ten-year inflation-adjusted) earnings we can just add 2017’s earnings (493) to the sum of real earnings over the previous nine years (4,244) and then calculate the average:
- 2017 cyclically adjusted earnings = (493 + 4,244) / 10 = 474 index points
This compares badly to cyclically adjusted earnings a year ago, which were higher at 517 index points. The reason again is declining profits over the last three years and 2016’s especially weak results.
Forecasting fair value at the end of 2017
On the basis that cyclically adjusted earnings at the end of 2017 are forecast to be 474 index points and that the fair value CAPE ratio is 16, we have:
- 2017 fair value for the FTSE 100 = 474 * 16 = 7,580
This is lower than last year’s fair value of 8,272 because, as we saw in the previous section, the cyclically adjusted earnings are forecast to be lower.
A declining fair value is of course not what investors want to see, but there is little we can do about it (other than invest outside the FTSE 100 or cherry-pick the best companies at the best prices from the index).
Forecasting expected value at the end of 2017
If you decided to skip the maths then this is the bit you’re looking for. If you didn’t, then hopefully you have a much better idea of where this forecast came from, and more importantly that it did not come out of a hat.
The final forecast is based on the fact that market valuation ratios tend to revert towards their historic averages (or means), a process known as mean reversion.
This can take many years and of course is not smooth or predictable, so my assumption here is that the market will close the gap between its current and fair CAPE ratios by half over a one-year time horizon, at which point the market will be at its expected CAPE ratio.
Looking at the history books we know that at the end of 2016 the FTSE 100 stood at 7,120 and had a CAPE ratio of 14.7 compared to a fair value CAPE ratio of 16. So the market was slightly cheap, but not exactly in bargain territory.
The expected CAPE ratio is then easy to calculate:
- 2017 Expected CAPE ratio = (14.7 + 16) / 2 = 15.4
Now that we have an expected CAPE ratio we can easily work out the expected value for the FTSE 100 by combining the forecast cyclically adjusted earnings (474) and the forecast expected CAPE ratio (15.4):
- 2017 Expected value for the FTSE 100 = 474 * 15.4 = 7,277
Today the FTSE 100 stands at 7,160 and so the expected change in its value over the next year is small at just +1.6%.
Of course there is a lot of false accuracy in quoting the forecast value to four significant figures, so please remember:
- This is effectively a probability-weighted average of all possible values
- The full range of possible values is very wide, most likely spanning several thousand index points
- Values further way from the expected value become gradually less likely (e.g. 4,000 or 10,000 are far less likely than 7,300)
Despite all the necessary caveats I do think this forecast is a good indicator of what we might reasonably expect the market to do over a one-year period, and on that basis I am very mildly bullish on the FTSE 100 for the rest of 2017.
Finally, here’s a chart showing the FTSE 100 and its CAPE valuation over the last 30 years, including the 2017 forecast: