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 repeatedly 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 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:
Here we can see that the static “resistance” which exists at the 7,000 level is simply a temporary anomaly, caused by two successive bubbles (one in tech stocks, one in housing and banks).
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 a 5.5% growth rate will be repeated until 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)
Another excellent article, John. I always looks forward to this analysis and I think you’ve nailed it again!
The FTSE-100 also has a geographically diverse income base which spreads risk for investors, rather than it being tied to one economy or currency. This makes it very attractive for long term UK investors.
I’d argue the dividend yield is a little stretched right now, so that even your third indicator looks close to fair value, rather than cheap. Do you have a forecast for dividend cover? (I see plenty of data on trailing 12-month cover but it’s pretty irrelevant given the recovery in oil prices and bank earnings)? I’d expect a number close to 2 if we are close to historic averages. I’m guessing the answer might be between 1.5 and 2 today, which might indicate we are a little stretched right now.
Also, what is the source of your 30-year dividend yield data, please?
Thanks Jonathan. Dividend cover is an interesting topic. Over much of the last year or so the FTSE 100’s dividend has been uncovered, i.e. dividend cover was below one. I have been waiting to see whether the dividend would start to decline, or whether earnings would recover. My wait could be over because in recent months, FTSE 100 earnings have recovered rather dramatically (up about 60% from a year ago).
Cover is now 1.2, which is not brilliant but hopefully it will improve.
As for the dividend data, it comes from a variety of sources, which become increasingly dubious the further back in time they go. Recent data is from the FT Market Data Archive (https://markets.ft.com/data/archive), data going back to the early 90s is from the book “How to value shares and outperform the market” and 1980s data is, if I remember correctly, extracted from a chart published by Hargreaves Lansdown.
Although the basic arguments are convincing, isn’t there a large elephant in the room? Is it not possible that at least a few of our FTSE 100 companies will function better outside the UK within the next few years and will list their shares accordingly ? Shell, Unilever, Astra Z etc. may feel that their business models may benefit from transferring permanently to the nationality of their “other half” ? HSBC and Vodafone may well benefit if they re-located to an EU state.
One of the major reason for the mini boom in the FTSE has been the weakness of the Pound benefiting companies who derive a large proportion of their income from overseas. If new tariffs and/or taxations stemmed this flow then surely their profits (and share price) would fall or they would be forced to put their HQ outside Britain .
Hi David, that’s a good point and unfortunately I’m sure there are many other elephants in the room too.
For the most part they are highly uncertain possibilities and how they affect the economy and stock market are even more uncertain. That’s why my general policy is to ignore “events” and focus on longer-term trends such as inflation and real economic growth, which are hopefully more reliable.
As for companies moving to other indices, this doesn’t affect investor wealth because they’ll either be given shares on the new exchange or some other form of like-for-like compensation.
John
Oh how I’m missing your famous rainbow chart (the heat map / fan chart showing how your extrapolation of the data is naturally prone to a larger margin of error for each unit of time going forward). Anyway, thanks for your insights again, as someone living off my portfolio and other investment income I’m naturally always interested in this aspect of your work.
All the best, Ric
David
Whilst I share your brexit concerns, I hope the economy will recover and in years to come brexit will be just another blimp on the graph, much like 2000’s tech bubble & 2008 banking crash.
Hi Ric, the rainbow chart will make a comeback at some point I’m sure. I just wanted to try something different, mostly with arrows, and I thought arrows on the rainbow chart might give some readers a headache!
Keep your eyes peeled for year-end reviews of the FTSE 250, S&P 500 and UK housing market…
Thanks so much john i always appreciate your analysis. Cant do it myself!
You’re welcome Dawn, your appreciation is appreciated.
I think the FTSE 100 is where it is because of the fall in the Pound (70% of FTSE 100 profits come from abroad) and relative to interest rates, which are at historically low levels, it makes sense for the index to move upwards. On a purely yield basis shares look good value compared to what is achievable in savings accounts / government bonds.
However, the real driver of the FTSE is what happens in the somewhat more expensive US market – US tax reforms, if they happen, could take that market considerably higher, besides the US economy is growing well at the moment – better than ours – and on average better than the Eurozone even.
What could kill the FTSE rally is a Corbyn government – higher taxes etc … would see a lot of companies hard hit and many I suspect will move their HQs to friendlier jurisdictions such as Eire, basically eroding the corporate tax base.
Hi Justin, in the short-term I agree. Many of the factors you mention will be important for where the UK market goes, but unfortunately they’re all unpredictable, hence my simple “central estimate” approach.
Over ten years or more I think those factors will be much less important than inflation and general economic growth, which are much less likely to be reversed than a Corbyn government or a US bull or bear market.
Another viewpoint……………interesting article
Neil Woodford warns of stock market ‘bubble’
Fund manager: ‘There are so many lights flashing red, I’m losing count’
https://www.ft.com/content/64bfef5c-d5d0-11e7-8c9a-d9c0a5c8d5c9
Hi Barry, I saw that article the other day and was somewhat surprised by the headline. But in the interview he talks about Bitcoin, junk bonds, leveraged ETFs and “expensive defensive” stocks, but not the stock market in general.
So I don’t think he think’s the market is overvalued as a whole, especially as he keeps talking about how cheap UK cyclical stocks are (and I’d agree with him on that point).
Unfortunately Neil Woodford’s stock market (i.e. the 130 stocks in his Equity Income Fund) has already had it’s bubble burst, so it’s a little trite to point to the overall market — perhaps had he chosen other parts of the overall market he would be in better shape.
It’s difficult of course for Neil to pen an article on individual stock picking, as his skill in this area has been somewhat tested over the last 3-4 years.
LR
Great analysis, as usual. One thing that puzzles me is (given the largely multinational nature of the FTSE100) is why US shares are apparently much more expensive than FTSE-listed ones? Why is this difference not arbitrated away? Or, put another way, why do investors have so much more faith in US-listed business than UK-listed ones?
Hi Ludo, I think you’d have to look at the underlying companies to come up with a reasonable answer. Probably quite a lot of it has to do with the global prominence of the US market, sucking in more investors than elsewhere. Also the “FANG” companies, and other high profile tech stocks. And of course, belief in the US economy.
As for arbitrage, I think the positive feedback loop between performance and inflows (i.e. investors invest in a stock market because it’s gone up, thereby causing it to go up further, which pulls in more investors, etc) is more powerful. In the longer-term mean reversion and arbitrage will win, but in the shorter-term momentum is usually in the driving seat.
My tuppence worth of opinion (and that’s all anyone can legitimately claim!) is that there will be a rush for the exits in government bonds sometime in the next decade, and that lot of cash will want a home. Few markets are deep or fluid enough outside of shares to accommodate, so I expect this to drive prices up considerably, maybe even causing another bubble.
Anyone who hasn’t read John’s terrific book should do so. As I said before, it deserves it’s place on any investor’s bookshelf right beside Ben Graham’s classic.
I think at some point, John, I for one would find it useful if you updated it to include the new lessons you are teaching us along the way!
As ever, brilliant. Thank you.
🙂
Hi James, interesting point on bonds. I think you could be right, but the timing is so uncertain I’d put it in the “important but speculative” category. That’s where I also keep my thoughts on the impact of Brexit, which is another important topic I try to ignore.
As for the second edition of the book, I have 2020 pencilled in as the publication date. I think an update very five years or so is a good pace. It’s long enough to have a decent amount of new content and new examples, and it gives me enough time away from the book to preserve my sanity!
John,
Good update on a nice regular theme.
It would be an interesting extension to this article if you were to exclude oil and commodities.
The market was holding around the 7400 level for a period pre – and post the oil and commodity drop and recovery — if you stripped out the massive recovery in commodity and oil of late, the rest of the market has sunk quite heavily — particularly noted on the announcement by any company of results or interim reports.
I guess the CAPE of the rest of the market index is significantly lower than 16 (at a guess) and therefore represents better value, particularly if you have no interest as an investor in oil or other commodity stocks.
LR
Hi LR, interesting but probably a lot of work too!
“Forecasters just make astrologists to look respectable” a great economist said.
The last thing I would try to figure out is where FTSE 100 would be in 10 years time. It could be anywhere between 3000 and 10,000. And if any of those happen, so what? My life won’t change. I will actually be better of if it goes to 3,000 than 10,000.
As long as I stick with my investment process, I will let FTSE 100 to take care of itself. I think we are loosing too much time looking at FTSE100 all day!
Hi Eugen:
“The last thing I would try to figure out is where FTSE 100 would be in 10 years time” – I’m not so much trying to work out where the FTSE 100 will be, I know that’s impossible. I’m just trying to give investors a sensible idea of what a reasonable educated guess would be. More technically, my “forecast” is an estimate of the expected value (in a statistical sense), i.e. the probability-weighted average of all possible values at that point in time.
As for whether this is worth doing, I think it is. If the 28-year old version of me had read an article in the year 2000 explaining how the market was extremely overvalued, and how it was likely to be lower in 2010 than in 2000, then I might have positioned myself accordingly. Rather than expecting the 10% or 20% annual gains I’d seen every year since 1995 to continue forever, I might have realised that the market at that time was incredibly risky and reduced my portfolio’s then 100% UK equity exposure.
So yes, I think this is a useful thing to do, because most investors are constantly bombarded by short-term, news-based analysis that is about as much use as a chocolate fireguard.
“It could be anywhere between 3000 and 10,000.” – It could be, but it’s unlikely to be in that range in ten years and very unlikely to be 3,000. For it to be at 3,000 in ten years we’d need to have massive deflation of Sterling or a near-total collapse of the UK and global economy. More realistically, if we have inflation at around 2% and real growth at around 3%, the FTSE 100 could reasonably be somewhere between half and double its expected value (a historically achievable range), so somewhere between 6,500 and 26,000, if I round the expected value up to 13,000.
” I think we are loosing too much time looking at FTSE100 all day!” – I totally agree. Most market analysis is a complete waste of time; either too short-term or focused on news and sensationalism rather than long-term fundamentals.
I was wondering what affect rising bond yields would have on the FTSE100. There is an assumption that higher bond yields may require FTSE100 yields to also be higher. After all, you would want more reward from the increased risk & volatility of stocks compared to bonds. However, when I Iook at the 30 year FTSE100 yield and compare that with historic (10 year UK) bond yields then I see no correlation.
Maybe the markets getting spooked by the possibility of rising bonds yields is just that, the markets getting spooked, but no reason for a long term change and no long term influence in FTSE100 prices. The US is a different kettle of fish though.
Just thinking aloud.
AAJ – clueless investor –
In theory the two should be linked and in practice they probably are, but very loosely. If you look at Prof. Robert Shiller’s data on the US it shows interest rates versus S&P 500 since about 1880. There is a clear relationship where falling interest rates leads to rising markets (i.e. lower dividend yields) and vice versa, but as I say it’s super loose. Personally, as an equity investor I think there is little or no practical value in looking at bond yields.
You can download Shiller’s stock market data spreadsheet here:
http://www.econ.yale.edu/~shiller/data.htm
Hello John,
Wondered if you could trouble you briefly give me your opinion about the activity of the last few days which is being referred by most commentators a ‘sell off’ and even a ‘crash’ by some
I am mostly invested in household name FTSE 100 stocks that I have researched to the best of my ability. and have averaged around 9/% a year over the last four.I have not been tempted to sell, but have experienced losses of around 5 to 6 %. Of course has not happened for a while, and I suppose like many investors my nerves are jangling right now.
Regards,
Peter
Hi Peter
To be honest I’m surprised at the amount of coverage this little “correction” is getting. Technically, a correction is a 10% decline from a previous peak and it’s the smallest decline which is even worth mentioning. Anything less than 10% is just typical daily noise.
The FTSE 100 has fallen from an all-time high of about 7,800 to about 7,100 today, which is just shy of that magic 10% mark. So yes, we’ve more or less had a technical correction, but so what?
Does this correction mean the bull market is over? Nobody knows.
Does it mean we’re about to suffer a major bear market? Nobody knows.
Is it just a little “whipsaw” to get rid off the obvious excessive enthusiasm in the market (primarily a US issue rather than UK)? Nobody knows.
What I do know is that the FTSE 100’s dividend yield is 4.1%. That’s above the average (which is closer to 3%) and so by that overly simple measure, the FTSE 100 is an attractive place to invest.
If the FTSE 100 falls to 5,000 then the dividend yield will be 5.8%. How long do you think that sort of yield will be left on the table? Not long, I imagine. So if there is a bear market (20%+ decine) I doubt it will be long lived and the rebound could be as impressive as the one in 2009.
So the lesson here could be similar to the one in the 2000-2003 bear market or the 2008-2009 bear market. If you jump ship at the point of maximum fear (2003 or 2009) then you are very likely to suffer a lot of pain as the market rebounds without you.
Personally I am not really interested in this 10% decline, other than as an opportunity to buy good companies at lower prices. So again, the general point is that long-term investors should focus on valuation multiples, which become more attractive as the market falls.
As for jangling nerves, I would say perhaps turn off the TV/phone/etc and think about where your portfolio might be in five or ten years, rather than where it might be in the next five or ten days, weeks or months.
Thanks John this is what I needed to hear.