The UK stock market could be riding for quite a fall. That, at least, is the message coming from the current valuation of London-listed Investment Trusts. Currently, the UK Investment Trust sector as measured by Thomson Reuters Datastream is trading at a slight premium to book value of 1.01 times.
Over the past 35 years, this single metric has been a much better predictor of returns over a one-year horizon than any valuation indicator. A strategy of buying the market every time the ratio was below 0.88 and switching into interest-bearing cash above this level would have produced a compound annualised return of 19% after reinvested dividends but before trading costs. 
What is especially interesting here is that the short-term outlook implied by the Investment Trust premium is at odds with the medium- to long-term outlook that I highlighted in this recent report. Based on a series of valuation measures, the UK stock market is likely to deliver modest positive total returns after inflation over the next 5 years or so.
That’s almost 2 standard deviations above the average since 1980 of 0.83. If history is any guide, this is bad news for the outlook for the FTSE All-Share index.
The price/book ratio in the case of Investment Trusts – which are closed-ended investment funds – compares their stock market price with the net asset value of the shares that the trusts have invested in. Collectively, UK Investment Trusts have tended to trade at a discount to their net assets, on a price/book ratio of less than 1.
The price/book ratio in the case of Investment Trusts – which are closed-ended investment funds – compares their stock market price with the net asset value of the shares that the trusts have invested in. Collectively, UK Investment Trusts have tended to trade at a discount to their net assets, on a price/book ratio of less than 1.
Since January 1980, they have done so for more than 90% of time. Only a handful of occasions has the ratio gone much above 1 – and almost all of them ended badly.
In September 1987, UK investment trusts’ price/book ratio hit 1.07, just a few weeks before the legendary “Black Monday” meltdown. Even higher ratios around the time of the millennium were followed by the savage losses of 2002-03.
In September 1987, UK investment trusts’ price/book ratio hit 1.07, just a few weeks before the legendary “Black Monday” meltdown. Even higher ratios around the time of the millennium were followed by the savage losses of 2002-03.
Most recently, the peak valuations of early 2008 came ahead of the worst of the credit-crunch bear market. Only in early 1994 was a stretched price/book ratio in this segment of the market not followed by disaster.
Over the past 35 years, this single metric has been a much better predictor of returns over a one-year horizon than any valuation indicator. A strategy of buying the market every time the ratio was below 0.88 and switching into interest-bearing cash above this level would have produced a compound annualised return of 19% after reinvested dividends but before trading costs.
By comparison, merely buying and holding the market would have made a mere 12.3%. What’s more, such a strategy would have run far less risk, incurring 12.2% annualised volatility versus 16.6% for buy-and-hold.
Is the FTSE All-Share doomed to suffer losses over the next twelve months, based on Investment Trusts’ current valuation? Although the odds favour poor returns, there are other possibilities. One of them is that Investment Trusts get even dearer as the market pushes higher.
Is the FTSE All-Share doomed to suffer losses over the next twelve months, based on Investment Trusts’ current valuation? Although the odds favour poor returns, there are other possibilities. One of them is that Investment Trusts get even dearer as the market pushes higher.
But this would surely raise the risk of even more painful losses down the road. Another is that the relationship may break down. However, there’s no compelling reason I can think of why it should do so.
What is especially interesting here is that the short-term outlook implied by the Investment Trust premium is at odds with the medium- to long-term outlook that I highlighted in this recent report. Based on a series of valuation measures, the UK stock market is likely to deliver modest positive total returns after inflation over the next 5 years or so.
Of course, there is nothing to say that the FTSE All-Share won’t suffer a poor twelve months starting now and then enjoy a good next four years. Weakness on Wall Street – triggered by the end of Quantitative Easing – provides an obvious trigger for poor near-term returns in the UK.
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