2017 is drawing to a close, so once again it’s time for my semi-regular UK stock market review.
In this case I’ll be looking at the FTSE 100’s current valuation and making a fact-based forecast for 2018. I’ll also use that same approach to make a forecast for the next decade.
In my opinion the FTSE 100’s valuation is more important than any forecast, so let’s have a look at valuation first.
Is the FTSE 100 expensive?
The large-cap index has repeated hit all-time highs during 2017, and at a current price of 7,400 it sits only a few points below the highest ever.
Even worse, over the past 20 years the FTSE 100 has repeatedly failed to sustainably exceed 7,000. When it’s reached that level in the past, it has subsequently fallen dramatically as the chart below shows:
This is a worrying picture. If history is anything to go by, it looks as if the FTSE 100 is probably going to collapse any moment now and plunge back below 5,000.
That is a reasonable interpretation of the past, but if we look at the past 30 years rather than the past 20 years, the picture changes dramatically:
In other words, the 7,000 level is irrelevant and what really matters is that long-term growth trend (which, in case you were wondering, is driven by a combination of inflation and real economic growth).
In terms of valuation, we can assume that the trend line is approximately “fair value” for the FTSE 100.
The chart above then clearly indicates that the FTSE 100 was expensive at the end of 1999 and 2007 (after which the index collapsed) and cheap at the end of 2002 and 2008 (after which the index skyrocketed).
- Today the FTSE 100 is very close to its long-term trend line, suggesting the index is close to fair value despite also being close to its all-time high
Of course, this is just one way to analyse the market’s value and there are other, perhaps better ways.
Is the FTSE 100’s PE ratio high or low?
Perhaps the best known valuation tool is the humble price to earnings (PE) ratio.
It’s easy to calculate and easy to use; you simply compare today’s PE ratio to the long-term average ratio. If today’s ratio is far above or below average, then the index is either expensive or cheap, respectively.
However, earnings are cyclical. High earnings during a cyclical boom can make the PE ratio look artificially low, while low earnings during a cyclical bust can make the PE ratio look artificially high.
To get around this problem we can use the cyclically adjusted PE ratio (CAPE).
CAPE uses ten-year average earnings which are far more stable than annual earnings, and it adjusts them for inflation too. The result is a much more stable ratio which is my preferred valuation tool for market indices.
Using the CAPE ratio is as simple as comparing today’s value to its long-term average. For example:
- Dot-com bubble: At the end of 1999 the FTSE 100 stood at 6,670, giving it a CAPE ratio of 32. That’s double the long-term average of about 16.
- Financial crisis: In March 2009 the FTSE 100 fell below 3,700, giving it a CAPE ratio of just 8. That’s half the long-term average of about 16.
Those results correlate nicely with the previous trend-based analysis, with both methods suggesting the FTSE 100 was expensive in 1999 and cheap in 2009.
So what does the CAPE ratio have to say about the current level of the FTSE 100?
With the FTSE 100 at 7,400 its CAPE ratio is currently 16.5, just slightly above the long-term average of 16 (shown in the chart as the flat red line).
This correlates with the previous trend-based analysis, so:
- The FTSE 100’s middling CAPE ratio suggests that the FTSE 100 is close to fair value and is not expensive
At the risk of beating this topic to death, here’s one more relevant question:
Is the FTSE 100’s dividend yield high or low?
Another popular and empirically reasonable way to value markets is to look at their dividend yield.
In many ways the dividend yield is a more robust measure than the standard PE ratio, especially for market indices rather than individual companies.
That’s because, much like the CAPE ratio’s ten-year average earnings, an index’s dividend is typically very stable from one year to the next.
Thanks to the stability of the dividend, we can be pretty sure that a low dividend yield does indeed mean the market’s expensive, and vice versa.
The FTSE 100’s dividend yield, with the index at 7,400, is currently 3.9%. So how does that stack up against the index’s long-term average dividend yield?
The answer is, quite well.
The FTSE 100 has an average dividend yield over the past 30 years of 3.3%. This is in line with longer-term average yields and average returns.
For example, over more than a century the UK’s total stock market returns have averaged about 5% per year after inflation. This has typically come from a combination of dividend growth at 2% above inflation plus a dividend yield of about 3%.
The current relatively high dividend yield of 3.9% is in line with, but slightly more optimistic than, the previous two valuation methods:
- The FTSE 100’s high dividend yield suggests that the index is slightly cheap and not expensive
From valuation to forecast
Two of those valuation methods indicate that the FTSE 100 is probably close to fair value while the third (the yield method) suggests it is slightly cheap.
Expensive markets produce poor returns, cheap markets produce good returns and averagely priced markets produce average returns, so we should expect future FTSE 100 returns to be close to, or perhaps slightly above, average.
That isn’t much of a forecast, so here’s one way to calculate a more concrete forecast:
Over the past 20 years the FTSE 100’s cyclically adjusted earnings (i.e. ten-year inflation adjusted average earnings) have increased by about 5.5% per year (made up of inflation and real growth of about 2.7% each).
To make life easy, and because nobody knows what the future will bring, I’ll assume that 5.5% growth rate will be repeated to the end of 2018.
Since the FTSE 100’s CAPE ratio is pretty much spot on its long-term average of 16, and because there’s no obvious reason to expect it to go shooting off towards 32 (as it did in the dot-com bubble) of diving down towards 8 (as it did in the financial crisis), I’ll assume that the CAPE ratio remains more or less unchanged at 16.
This makes the forecast very easy.
With cyclically adjusted earnings going up by 5.5% and the CAPE ratio staying unchanged, my forecast is for the FTSE 100 to increase by 5.5%. In other words:
- The FTSE 100 could easily reach 7,800 within the next year
Of course, you should not expect this forecast to be right. Instead, think of it as a sensible fact-based estimate of where the market could be in a year’s time.
A long-term forecast for the next decade
Given the FTSE 100’s relatively fair value, a longer-term forecast is also easy to calculate; simply extrapolate that 5.5% rise in cyclically adjusted earnings for ten years.
The result is a rise in cyclically adjusted earnings by about 72%, which leads to the following rather interesting forecast:
- The FTSE 100 could easily reach 12,700 within ten years
12,700 may seem ridiculously optimistic given that the FTSE 100 has been stuck at or below 7,000 for the best part of 20 years.
But as I said at the beginning, the 7,000 level is a temporary anomaly caused primarily by the enormous dot-com bubble. What really matters is the long-term growth trend, driven by inflation and real economic growth.
And that growth trend could easily see the FTSE 100 get within touching distance of 13,000 within the next few years.
We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten – Bill Gates (probably paraphrased slightly)