UK stock market valuation and long-term forecast

Is the UK stock market cheap or expensive compared to historic norms? And are its returns over the next decade or so likely to be good, bad or ugly?

To find out, I’m going to look at the current valuation of both the FTSE 100 and FTSE 250. After that I’ll wrap things up with a long-term forecast for both indices.

Expensive or cheap compared to what?

For the price of something to be expensive or cheap you need to something else to compare it to.

Many people compare the price of the FTSE 100 to its price last week, last month or last year; but that’s a really bad idea.

A much better idea is to compare price to earnings.

When I looked at the UK housing market last week, I compared average house prices to average UK worker earnings since 1983. That’s a sensible approach and it can be applied to the stock market in almost exactly the same way.

This is easy to do because the price to earnings (PE) ratio for both the FTSE 100 and FTSE 250 are published on a daily basis by the FT in its World Markets at a Glance report.

There is a snag though.

With the housing PE ratio, earnings are very stable because the average wage in the UK hardly changes from one year to the next. And that’s good because you need to compare prices to something that’s consistent over time.

But corporate earnings aren’t consistent from one year to the next.

For example, at the start of July the FTSE 100 stood at 7,637 with a PE ratio of 13.33. So the index had earnings of 573 index points. In contrast, at the start of 2017 the index stood at 7,120 points with a PE ratio of 33.6, so its earnings back then were just 212 index points.

That’s an earnings increase of more than 150% in 18 months, which means year-to-year corporate earnings are very volatile and largely useless for valuation purposes.

CAPE comes to the rescue

Fortunately there’s an easy way to remove most of this volatility, and that’s by averaging earnings over a ten-year period.

The result is the PE10 ratio, although a more popular alternative is the inflation-adjusted version, commonly known as CAPE (cyclically adjusted PE).

CAPE is very useful because we have lots of data which says:

• When CAPE is far above average, stock market returns over ten to 30 years or so are likely to be far below average.
• When CAPE is far below average, returns over ten to 30 years or so are likely to be far above average.
• When CAPE is about average, returns over ten to 30 years or so are likely to be about average.

In fact, it’s pretty easy to come up with standards for “expensive” or “cheap” based on the historic CAPE record for the FTSE 100 and FTSE 250. We can then compare where the indices are today compared to those historic standards.

The FTSE 100 is not expensive, despite being near all-time highs

Over the long-term, across many markets, CAPE tends to stay somewhere near the mid-teens. In the UK, since the mid-80s, it’s been as high as 30 and as low as 10.

Its average over those 30-odd years is about 18, although I tend to assume the longer-term average is 16 because the last 30 years includes the biggest valuation bubble in recent history (the dot-com bubble of the late 90s).

Here’s a chart showing my definitions of varying degrees of expensiveness and cheapness for the FTSE 100, based on the idea (backed up by quite a bit of data) that CAPE tends to stay in a range of between 8 and 32, with an average of about 16:

Here’s some context: In the great dot-com bubble, CAPE was about 32. In other words, investors were paying 32-times the index’s average earnings to invest in those one hundred companies.

If we were at that sort of level today, the FTSE 100 would have to be above 14,000.

So despite being at all-time highs, the FTSE 100 is about half as expensive as it was twenty years ago, relative to the profits produced by the underlying companies.

That’s backed up by the dividend yield, which is 3.8% today compared to a mere 2.1% near the height of the dot-com boom.

All of this suggests, very strongly, that the FTSE 100 is nowhere near expensive by historic standards.

And relative to the housing market the FTSE 100 is an absolute bargain (although in reality it’s difficult to make direct real-world comparisons between the two because they’re very different animals).

Before we move on to the FTSE 250, here’s a chart showing the valuation bands from the table above along with the actual value of the FTSE 100.

In effect, the rainbow shows the range of possible values the FTSE 100 might have taken under most conditions, with only extreme bubbles and depressions lying outside the rainbow:

The FTSE 250 is getting warm, but is not yet hot

Unlike the FTSE 100, the FTSE 250 has left its dot-com bubble price in the dust (which is because it didn’t really have a dot-com bubble in the first place).

As you might expect, this rapid price increase has driven the FTSE 250’s CAPE ratio up to the point where it’s above average.

For the FTSE 250, the average CAPE is around 20 rather than 16. That’s because the mid-cap index typically trades on higher valuations than the large-cap index, probably because on average it’s made up of smaller, higher growth companies (and higher growth tomorrow means higher valuations today).

As the table below shows, the expected range for the FTSE 250’s CAPE ratio is between 10 and 40 (half and double the average of 20), and at 20,831 the FTSE 250 sits only very slightly above that mid-range level:

For the FTSE 250, its peak valuation came at the peak of the mid-2000s credit boom rather than the late-90s tech boom.

It’s CAPE ratio went above 32 just before the crash and so today’s CAPE ratio of about 24 is warm, but some way short of expensive, let-alone an outright bubble.

Interestingly enough, the FTSE 250’s earnings over the last ten years are double what they were in the ten years leading up to the credit crunch, so the index’s higher price is well-supported by much higher earnings.

To show you what that looks like, here’s another rainbow chart showing the CAPE ratio bands for the FTSE 250. Again, think of the rainbow as showing the range of reasonably likely values for the FTSE 250:

As you can see, the FTSE 250 sits very slightly above the yellow “normal” valuation range, but only very slightly.

Market forecast: Normal valuations mean normal expected returns

As I mentioned at the outset, normal CAPE ratios imply normal expected returns over say ten to thirty years.

For both indices this means something in the region of 7% per year, on average, made up of both capital gains and dividend income.

The “on average” bit is important.

Why?

Because even if the expected return is 7%, you shouldn’t expect to get 7% every year, or even anything close to that.

It’s like playing a game of dice where the odds are stacked in your favour. Roll a one or two and you lose a pound. Roll three, four, five or six and you win a pound.

Over six rolls you’d expect to have won four pounds and lost two pounds, giving you a net gain of two pounds. But in reality you might have lost six pounds, gained six pounds, or anything in between.

On any single roll your expected return is 33p (two pounds divided by six possible outcomes), but you obviously won’t actually get 33p since you either win a pound or lose a pound.

So 33p is the expected return per roll, but you shouldn’t ever expect to get the expected return on a single roll.

However, over 100 rolls you really can expect to have won something fairly close to 33p per roll, on average. And the longer you play, the closer your average return will get to the expected return.

And it’s exactly the same in the stock market.

Over a single year you might lose 20% or gain 20%, but over ten, 20 or 30 years you can reasonably assume your average return will be close to the expected return.

And at the moment, thanks to the UK stock market’s fairly average CAPE ratios:

• You should expect fairly normal total returns from the UK stock market between now and some date at least ten years in the future.
• History suggests the market will return an average of about 7% per year over that sort of time-frame, given today’s average starting valuation.