It’s time for another one of my semi-regular FTSE 100 valuation and forecast updates, using the latest data for both the index’s price and its earnings.
Valuing the FTSE 100 using CAPE
My tool of choice in the valuation game is Robert Shiller’s CAPE (Cyclically Adjusted PE). CAPE is basically the same as the PE ratio that most investors are familiar with, except that is uses 10-year inflation adjusted earnings as the “E” part of the ratio.
It does that because the 10-year earnings average is a much more stable number from one year to the next than just a single year’s earnings. That’s important because we want something nice and stable to compare the FTSE 100’s price to.
In other words:
CAPE is like measuring the distance between two points on the ceiling while stood on a solid table, whereas the standard PE is like doing the same measurement stood at the top of a wobbly step-ladder.
You’ll get an accurate measurement with one and a dangerously inaccurate one with the other (dangerous if you fall off the ladder anyway).
Calculating “fair value” for the FTSE 100
Today, the FTSE 100’s 10-year inflation adjusted earnings stand at 530 index points. I’ve put the value into index points because that’s how the index is measured.
So with a current price of 6,700 index points, the FTSE 100’s CAPE is 12.6.
That’s actually pretty low. The long-term average, across multiple international markets, is somewhere in the mid-teens, around 15 or 16.
If the market were at “fair value” today, i.e. with a CAPE ratio of 16, it would be at 8,500. At that level it would have a dividend yield of 2.8%.
That sounds a little high (i.e. low yield) to me, but not significantly so as the market’s long-run average dividend yield is about 3% (we’re at 3.5% at the moment).
I could just stop there and say that the FTSE 100 is slightly below the typical long-run average of 16, and therefore it’s “slightly cheap”.
But that’s a bit dull, so here are a couple of visual tools to illustrate what the market’s valuation means for future returns.
CAPE is “mean reverting”, and that’s a good thing
First though I’ll take a little detour into the world of “mean reversion”, as that underpins everything else (skip this bit if you already know all this).
The FTSE 100’s CAPE is a mean reverting statistic, which simply means that the further it is from its long-term average, the more likely it is to move back towards that average.
This is a common feature of many financial statistics, such as the house price to earnings ratio.
Despite what some property pundits think, house prices are indelibly linked to the earnings of the people who either buy or rent those houses.
If a four bedroom flat in London is put on sale for £1, there will be a mad rush of buyers who will bid up the price to something more sensible.
If that same flat is put on sale for £100 billion there will probably be silence from potential buyers (or perhaps even a little astonished laughter). In that case the seller will have to lower the price (a long way) before any buyers become interested.
That’s why the UK house price to earnings ratio tends to hover around 4. Sometimes its falls to 3 or lower, as it did in the mid-1990s and sometimes it climbs above 5, as it did in 2008 and seems to be doing again today.
In the long-run, assuming that a mean-reverting ratio will be at its long-term average in 10 years or so is probably as good a way to estimate future returns as any. And that applies to any supply and demand-driven asset class, including the stock market and property market.
FTSE 100 CAPE probability “fan chart”
So, having gotten that introduction out of the way, here’s my first visual too, the FTSE 100 CAPE probability “fan chart”:
A few notes:
- The black line – is the FTSE 100 from 1987 to today
- The left axis – is logarithmic, which just means that each step up is double the previous step, which you can pretty much ignore if you want to
- The green bands – represent various CAPE valuation levels from a CAPE of 8 up to a CAPE of 32 (the average, in the middle, is 16)
- Darker greens – are the valuation range where the FTSE 100 has historically spent most of its time. This is where it is more likely to found be in future.
- Lighter greens – are valuation levels that the market rarely reaches. This is where it is less likely to be found in future.
So for example, the central dark green band is where the FTSE 100 would be if it had a CAPE ratio between 14 and 20, which is what I call “normal”. It is also the valuation range where the market is most commonly found.
As the chart shows, in the dot-com boom in the late 1990s, the FTSE 100 was way above “normal”. Since the market is most likely to be found in the dark green “normal” band in, say, 5 years’ time, the most likely move for the market from 1999 onwards was downwards towards that “normal” range.
And that’s exactly what happened, somewhat abruptly, in the 2000-2003 crash.
Another example is 2009, where the market dropped to 3,500 and was way below the normal (dark green) valuation range. The implication was that the FTSE 100 would rise in value back towards that normal valuation range in the next few years.
Once again that’s exactly what happened, as the market leaped upwards in value during the latter part of 2009 and 2010.
So today we effectively have a small (probable) tailwind thanks to a low valuation and CAPE’s mean reverting characteristics.
The market is likely to mean revert back into that dark green band at some point over the next decade, and since the FTSE 100 is below that level at the moment that means a valuation expansion rather than contraction.
That valuation expansion would of course be in addition to any earnings growth (typically about 4% a year) and dividends (3.5% a year with the FTSE 100’s current dividend yield).
That is, I think, the most likely outcome, but that’s very different from saying it’s the only possible outcome. The future’s not set and the FTSE 100 can do whatever it likes, within reason (as can the property market).
FTSE 100 CAPE-based future returns “heat map”
Because CAPE is mean reverting, it influences the future course of the market:
- When CAPE is high – future returns are likely to be low
- When CAPE is low – future returns are likely to be high
- When CAPE is normal – future returns are likely to be normal
With this insight it’s possible to re-draw the probability fan chart as a future returns heat map in order to highlight the relative “goodness” of low valuations and “badness” of high valuations.
A few more notes for the heat map:
- Red – implies low future returns
- Yellow – implies normal future returns
- Green – implies high future returns
Hopefully this more clearly illustrates the implications of various CAPE valuations, and the probability fan chart should remind you that these are “likely” outcomes and not guaranteed in any way, shape or form.
We all know how badly the market performed after 1999, and this heat map shows why. Valuations were sky high, and obviously so.
Then again, in 2009 valuations were low and future returns likely to be outstanding (as they have been, as long as you could stomach the fear).
In summary:
The FTSE 100’s CAPE valuation is “slightly cheap” at 12.6 compared to a long-term average across many different markets of 16.
The implication is that in the medium-term (5-10 years) total returns are likely to be slightly above normal, where normal is around 5% total return after inflation (so about 7% if we assume inflation at the Bank of England’s 2% target).
“Fair value” for the FTSE 100 is currently 8,500 (i.e. the value that would give the index a “normal” CAPE valuation of 16), and I think it is more likely than not that the index will reach that level in the next 5 years.