At the end of every year investment pundits love to write about their forecasts for the following year. For 2014 the consensus view was that the FTSE 100 would finally break through the 7,000 barrier.
It was and is an entirely reasonable target, but for one reason or another the index didn’t quite make it (although with almost two months to go it still might).
Personally I’m putting 2014 behind me and looking to the future. For most of my fellow pundits this will mean thinking about 2015 and whether or not the FTSE 100 will break 7,000, or perhaps even 8,000.
But I think looking to 2015 is too limited. The market might go up 10% or might go down 10%. Each is about as likely as tossing heads or tails.
The problem is that by looking at 2015 investors will be ignoring bigger questions such as, when could the FTSE 100 hit 10,000, or 20,000?
Such large numbers can appear ludicrous, and sometimes attract ridicule. But did you enter the stock market to gain 10%, or are you looking to double or quadruple your capital (or income) over the longer term?
If so then you need to be thinking about when the market might reach two or four times its current level.
Infinite growth on a finite planet
And that’s where the problems begin because at some point growth will stop. It’s as simple as that.
In the long-run there are obvious limits to exponential growth; to how many people there can be and how many goods and services they can consume on a single planet.
With this in mind I recently looked again at my FTSE 100 financial output data (i.e. its earnings and dividends) covering the past decade:
What struck me was the lack of growth in either earnings or dividends. Using an exponential trend line the earnings growth rate trend has been just 0.6% a year while dividends have a slightly faster growth trend at 2.6% a year. Averaging those two numbers gives a growth rate for the FTSE 100’s financial output of just 1.6% a year.
That sounds pretty weak, and it is.
CPI inflation over the same period has been 2.7% a year, so adjusted for inflation the economic output of the companies in the FTSE 100 has shrunk over the past decade.
Does this mean we’ve already hit the limits to growth? If that were the case then future returns from the FTSE 100 would be significantly reduced.
Looking for the signal in a noisy system
To answer that question we need to know if the last 10 years are indicative of a new long-term low-growth trend, or if it’s just a short-term blip, otherwise known as noise.
The critical factor we need to consider is timescale. In most systems the frequency of change due to noise is much higher than change due to a change in the underlying signal (the long-term growth trend in this case).
For example, the ratio between signal and noise frequencies on a telephone line may be 1,000 or more.
Or think of the global climate, where noise is the dominant factor over anything from a day to 20 years or so, and where the warming trend only becomes clear when you look at climate data over periods of 30 to 50 years or more.
To differentiate between noise and the underlying growth trend of the FTSE 100’s fundamentals we need to look at a longer period of time than just a single decade. So here’s all the data I have, which stretches back over more than 25 years:
In this chart, because of the longer time period, I’ve used a logarithmic vertical axis. That just means percentage changes at any point in time will look the same, so for example a 10% increase in earnings in 1990 will look the same as a 10% increase today.
Over this longer time period the underlying trend becomes a little clearer. I’ve added a couple of trend lines to show something approximating that trend.
During those 26 years earnings have been growing at about 6.4% a year and dividends at 4.5% a year. A reasonable estimate of the overall growth trend is 5.5% a year.
CPI inflation over this period has been 2.6% which leaves overall real growth at 2.9% a year.
If you look at the last decade’s relatively flat growth, it’s clear that growth has gone from above trend in the late 2000’s to below trend now. However, these differences are probably due to noise, i.e. short-term cyclical factors like booms and busts, as was the case with previous low-growth periods in the early 1990s and 2000s.
So while infinite growth on a finite planet is still impossible it doesn’t look like we’ve hit the buffers just yet, and in the longer term the FTSE 100 is likely to blow right past 7,000, and even 10,000, with relative ease.