Today the FTSE 250 stands about 50% above its pre-financial crisis highs and more than 200% above its post-crisis lows.
Those are impressive gains, but has it left the mid-cap market overvalued? I think it has, and the implications for expected future returns are not good.
Forecasting the FTSE 250 using Shiller’s CAPE ratio
Having recently gone through my forecasting approach in some detail (when forecasting the FTSE 100), I’ll just outline it here for reference. It basically involves forecasting:
- Inflation: For this I use the latest Bank of England inflation report
- FTSE 250 earnings: I assume next year’s earnings will equal the average real earnings over the previous decade
- Cyclically adjusted earnings: This is the FTSE 250’s ten-year average inflation-adjusted earnings up to the end of 2017 (i.e. including the earnings calculated above)
- Fair value: This occurs when the FTSE 250’s CAPE ratio equals its long-run average, which I take to be 20.
- Expected value: This occurs when the FTSE 250’s CAPE ratio is halfway between its current value and its fair value, and I assume this level will be reached a year from now. Why? Because market valuations tend to return to their long-run averages given enough time (a process known as mean reversion) and halfway is a reasonable estimate of how much the index could mean revert in a single year
Forecasting by numbers: A quick run through the maths
I’ll blast through the numbers fairly quickly. You can refer back to the FTSE 100 forecast mentioned above for more detail if you want it. You can also skip to the bottom of this article to see the final forecast if arithmetic is not your sort of thing.
First up is inflation which I’ll forecast to be 2%, based on the Bank of England’s latest inflation report:
- 2017 Inflation forecast = 2%
Next up is the FTSE 250’s earnings in 2017. I forecast this fairly conservatively as the average of the last decade’s real earnings, adjusted upwards to take next year’s inflation into account. The FTSE 250’s ten-year average real earnings are currently 763 index points, so:
- 2017 earnings forecast = 763 + (763 * 2%) = 778 index points
With next year’s earnings in place it’s easy to calculate the FTSE 250’s cyclically adjusted earnings for next year. We just need to add the 2017 earnings to the total real earnings of the previous nine years, which in 2017 will be 6,822 index points, and then take the average of the total:
- 2017 cyclically adjusted earnings = (6,822 + 778) / 10 = 760
Fair value is then the cyclically adjusted earnings (760) multiplied by the fair CAPE ratio, which I’m assuming is 20 (that assumption is based on data going back to 1993 plus an educated guess about what the data would have looked like before that).
- 2017 fair value for the FTSE 250 = 760 * 20 = 15,201
In this forecast mean reversion is expected to cause the gap between current CAPE (23.3) and fair CAPE (20) to close by half in the course of a year, so:
- 2017 expected FTSE 250 CAPE ratio = (23.3 + 20) / 2 = 21.8
We can then work out the 2017 expected value of the FTSE 250 by multiplying the expected CAPE ratio (21.8) by the forecast cyclically adjusted earnings (760):
- 2017 expected value for the FTSE 250 = 760 * 21.8 = 16,604
FTSE 250 forecast for 2017: Down by 8%
I’ll summarise the results here, especially for those who skipped the maths.
- Current value of the FTSE 250 today = 18,143
- Fair value of the FTSE 250 at the end of 2017 = 15,201
- Expected value of the FTSE 250 at the end of 2017 = 16,604
My forecast for fair value is just over 16% below where the index stands today. That reflects the current mild overvaluation I see in the FTSE 250, largely because of its above average CAPE ratio of 23.3.
For the expected value it’s still a decline, but of about 8% rather than 16%.
The expected return is still negative even if you include dividends at the current yield of 2.7%, and that’s why I’m mildly bearish on the FTSE 250 over the short-term.
I’ll finish this forecast with the same caveat-filled points from the FTSE 100 forecast:
There is a lot of false accuracy in quoting the forecast value to five significant figures, so please remember:
- Expected value 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. 10,000 or 25,000 are far less likely than 17,000)
Despite all the necessary caveats I do think this forecast is a good indicator of what we might reasonably expect the mid-cap market to do over a one-year period.
Finally, here’s a chart showing the FTSE 250 and its CAPE valuation since 1993, including this 2017 forecast:
It’s probably all true John, and the moral of the story is perhaps not to invest blindly in any index.
The preferred route is the one you follow, is to invest in good companies, with higher than average ROCE, has a history of consistent steady growth, is not heavily indebted and has some serious competitive advantages.
There are a few to be had — and they all differ in characteristics to the index.
LR
That’s a guess like many other guesses.
It will depend on how Brexit negotiations will start, if there is to be a trade war started by Trump and many other things, some of them harder to predict.
eneaugu, I’ve usually been relatively undeterred by macro political events. Over time they tend not to matter, that’s why the likes of Buffet et al turn modest sums of money into $millions.
LR
Excellent and timely review. What would be your advice for someone with a lump sum to invest?
I am keen ti build up an income generating growth portfolio but the high valuations are holding me back. On the other hand who knows when a correction and buying opportunity could arise and in the meantime I don’t get any interest in a bank account.
Thanks
I can’t give you any specific advice for regulatory reasons, but a few general points are:
1) I don’t think valuations are high (in general) in the UK stock market
2) Market timing (which is what you’re effectively trying to do by waiting for an attractive entry point) is generally a bad idea.
As you say you’re sitting out of the market, waiting for a correction or whatever. But what if it never comes? What if the market goes up and up from here for the next ten years?
I’m a fan of gradualism and so personally I would just get on with it and start dripping money into whatever I was going to invest in. But that isn’t advice.
You might want to look at some other educational material, such as on the Vanguard UK website.
The FTSE 250 is in the “normal” band of your rainbow graph, which seems a bit of a misnomer. If you expect it to fall then shouldn’t you label it “expensive”.
What do you make of CAPE telling us that the FTSE 100 is good value, but the FTSE 250 is expensive? A graph of FTSE 100 CAPE/FTSE 250 CAPE over time might be interesting. At present the value is about 1.65. What does this mean for shares that move from one index to the other? Should we steer clear of the smaller shares in the FTSE 100 because they’re similar to overpriced FTSE 250 shares, or perhaps buy larger shares in the FTSE 250 for the converse reason?
Hi Gilbert, just to clarify, I don’t expect the FTSE 250 to decline; it’s just that my estimate of its expected value (the average of all possible values at the end of 2017, weighted by probability) is lower than its current value.
More to the point, normal is a range, so the projection is for the FTSE 250 to decline from one normal valuation to another, with both being within the normal range. For the FTSE 250 to be expensive it would need to be above the normal range, which it isn’t.
Hopefully that makes sense?
As for the FTSE 100 vs the 250, I don’t make anything of their different valuations. They hold different companies operating in different sectors in different parts of the world, so I’m not surprised that they have different valuations. And their valuations aren’t very different anyway.
But yes, a FTSE 100/250 overlay of some sort might be interesting.
As for individual shares, I don’t think this sort of index valuation work has much to say about individual companies, other than that if an index is very cheap or expensive (which neither the 100 or 250 are) then the prospects for most companies within that index will be either unusually good or bad, respectively.
That’s because to a reasonable extent companies track what their index is doing, so when an overvalued index declines it may well reduce the share price of many companies that are not overvalued, making them even more attractively valued than they were to start with.
But using index valuations to make individual stock buy or sell decisions is probably taking their usefulness a step too far.