After a roller coaster first half of 2020, now seems like a good time to review the CAPE ratio for the FTSE 100, FTSE 250 and, for US-focused investors, the S&P 500.
FTSE 100 CAPE ratio review
The FTSE 100 has had a tough time over the last few years, largely thanks to the eurozone crisis of the early 2010s and, since 2016, Brexit. This has kept FTSE 100 valuations relatively low compared to historic norms.
More specifically, the FTSE 100’s CAPE ratio has been below average* since the market crash of 2008/2009.
*The FTSE 100’s average CAPE for the last 30 years is just over 18. However, that period includes the largest bubble in UK stock market history (the dot-com bubble) so I prefer to use the slightly more cautious figure of 16.
In keeping with these generally low valuations, the FTSE 100 entered 2020 at a price of 7,450 and with a CAPE ratio of 15.6, slightly below that average figure of 16.
Soon after that we ran head first into a global pandemic and the stock market reacted exactly as an experienced investor would expect.
Fear and panic led to a record-breaking collapse of share prices, followed by a quick rebound driven by a more pragmatic revaluation of long-term earnings expectations.
At the moment of maximum panic (March 23rd) the FTSE 100 fell below 5,000, a level first reached in August 1997, almost exactly 23 years ago.
When prices decline the CAPE ratio also declines, and with the FTSE 100 at 5,000 in March that gave the large-cap index a CAPE ratio of 10.3.
10.3 is significantly below the average CAPE of 16, suggesting that the FTSE 100 was likely to be very good value at that price.
To put that into context, the chart below shows the FTSE 100 against the normal range of possible CAPE valuation levels. It’s a range which extends from half to double the long-term average CAPE of 16.
GREEN = cheap, YELLOW = fair value, RED = expensive
The March 2020 low of 5,000 is clearly towards the bottom end of that valuation spectrum, implying there was little downside risk and much upside potential, at least from a valuation point of view.
Another way to think about the relationship between CAPE and future returns is to look at earnings yields instead of PE ratios. In other words, invert CAPE to turn it into a cyclically adjusted earnings yield figure, or CAEY:
Cyclically adjusted earnings yield = 1 / CAPE * 100%
March 2020 FTSE 100 CAEY = 1 / 10.3 * 100% = 9.7%
The earnings yield is a bit like the interest rate on a savings account. Of course, earnings can go up and down, but a 9.7% “interest rate” is still a very attractive starting point by historical standards.
Earnings which are not retained by companies are typically paid out as dividends, and in March the FTSE 100 had a dividend yield of 6.6%, more than double its long-term average of around 3%.
So regardless of whether you look at CAPE, cyclically adjusted earnings yield or dividends, one thing stands out:
At the moment of peak fear in March the FTSE 100 seemed to offer very good value.
Since then, the market has rebounded and as I write the FTSE 100 has recovered to 6,280. That’s a return of almost 26% in just four months, which is pretty good going by any reasonable standard.
This should not come as a surprise to value investors. After all, the fundamental principle of value investing is that high valuations (think dot com bubble in 1999) tend to produce low returns and low valuations (the recent panic in March 2020) tend to produce high returns.
Despite much gnashing of teeth over whether value investing still works or not, that fundamental principle has not changed one tiny bit.
At 6,280 today the FTSE 100 has a CAPE ratio of 13, which is slightly below the average of 16. Given that slightly low valuation, I would say this:
- The FTSE 100 is probably slightly cheap and is therefore somewhat likely to produce slightly above average total real returns (where average is around 7% per year) over the next five to ten years. If the index rose to “fair value” tomorrow it would grow by 24%.
FTSE 250 CAPE ratio review
The FTSE 250 has had a much better run over the last few years than the FTSE 100, having quadrupled in price from late 2008 (the depths of the credit crunch) to the start of 2020 (just before the pandemic set in).
Over the same period, the FTSE 100 barely doubled.
However, despite this impressive performance, the FTSE 250’s CAPE ratio has remained close to its historic average of 22 for most of the last ten years.
That was still true in the run up to the pandemic, where the FTSE 250 entered 2020 at a price of 21,880 and with a CAPE ratio of 24.
That’s slightly above average, but only slightly, so the implication is that the FTSE 250 was close to fair value at the beginning of 2020.
When the pandemic struck, the FTSE 250 was hit every bit as hard as the FTSE 100. In fact it was hit harder, possibly due to its higher starting valuation, with the mid-cap index falling more than 40% in about a month.
That was nothing more than blind panic, but if left the FTSE 250 at 12,850 and with a significantly lower CAPE ratio of 14. You can see this dramatic decline in the chart below.
GREEN = cheap, YELLOW = fair value, RED = expensive
14 is a long way below the “fair value” of 22, so the CAPE ratio was clearly suggesting that in March 2020 the FTSE 250 was likely to be very good value at a price of less than 13,000.
A CAPE ratio of 14 is equivalent to a cyclically adjusted earnings yield of 7%, so investing in the FTSE 250 in March was a bit like putting money into a savings account with a 7% interest rate. Equities are higher risk of course, but a cyclically adjusted earnings yield of 7% should give you some idea of just how attractively valued the FTSE 250 was at the time.
If you like to value investments by their dividend yield then the FTSE 250’s yield at that time was an impressive 5%. That’s not quite as high as the FTSE 100 but it’s still very good for an investment which has more than doubled its dividend over the last ten years.
As with the FTSE 100, the FTSE 250 appeared to be attractively valued precisely when investors were at their most fearful, so being greedy when others are fearful is more than just a cute Buffettism.
After the panic subsided the FTSE 250 recovered to a more reasonable level. As I write it sits at 17,230, giving those who sunk additional capital into the market in March a handsome gain of 34% in just four months.
As I’ve said before, good returns from low valuations should come as no surprise to value investors.
With the FTSE 250 at 17,230 it has a CAPE ratio of 19. That’s slightly below the “fair value” level of 22, so I would say this:
- The FTSE 250 is also probably slightly cheap, therefore mildly above average total real returns (where average is around 7% per year) are somewhat likely over the next five to ten years. If the index rose to “fair value” tomorrow it would grow by 15%.
S&P 500 CAPE ratio review
While the FTSE 250’s four-fold increase in price from 2008 is impressive, the S&P 500 can trump that with a near five-fold increase between the credit crunch of 2009 and its pre-pandemic all time high in early 2020.
That’s an incredible run, especially as capitalism was apparently on the brink of collapse in 2009.
After that record breaking ten-year run, the S&P 500 entered 2020 at an all time high of 3,260, a miraculous feat of expansion from its 2009 intra-day low of 666 (no, 666 is not a typo, it really did bottom out at that ominous number).
Through early 2020 the S&P 500 just kept on growing, reaching its current all-time high of almost 3,400 in February.
At that price the S&P 500 had a CAPE ratio of almost 32, which is nearly 80% above the 100-year average CAPE ratio of 18.
And then of course then pandemic panic began, wiping 35% off the US large-cap index in just a few weeks.
35% sure does sound like a big fall, but given the S&P 500’s lofty starting valuation it wasn’t even enough to take the market back to “fair value”, let alone anything that could be called cheap.
The moment of peak panic came in March, just as it had for the FTSE indices. For the S&P 500 the panic left it with a much reduced price of 2,240 and a CAPE ratio of 20; lower, but still above the 100-year average of 18.
To me this shows an astonishing degree of optimism.
Despite the world facing its first major pandemic in over 100 years, despite many countries telling their citizens to not go to work, not go to the shops, not to leave their homes, investors were still more optimistic about US companies than they had been, on average, over the previous 100 years.
And as if that wasn’t enough, as soon as the panic subsided investors, traders and speculators bid up US stock prices to the point where today the S&P 500 sits at 3,260, fractionally higher than it was at the start of the year and just 4% below its all time high.
In other words, Mr Market thinks the pandemic and its related global recession (“the worst economic downturn since the Great Depression“) will effectively have a net zero impact on the future earnings of the S&P 500.
This apparent disconnect between US market valuations and global economic conditions has led some notable investors to the conclusion that the US is very likely in a 24 carat solid gold stock market bubble.
Quoting someone who is considerably smarter than me:
“My confidence is rising quite rapidly that this is, in fact, becoming the fourth, real McCoy, bubble of my investment career. The great bubbles can go on a long time and inflict a lot of pain but at least I think we know now that we’re in one. And the chutzpah involved in having a bubble at a time of massive economic and financial uncertainty is substantial.”
Jeremy Grantham, billionaire value investor in an interview with CNBC
I’m not sure I’d call this a bubble just yet, but from a CAPE valuation point of view the S&P 500 is definitely in the somewhat hot zone, which is surprising given the extreme levels of uncertainty. And if the pandemic does take a sledgehammer to earnings over the next couple of years then yes, this could well be a full blown bubble.
When asked about the exposure investors should have to US stocks, Grantham said “I think a good number now is zero”.
That might be a bit extreme, but the army of armchair traders created during lockdown won’t listen anyway, because when you’re in a bull market, everyone thinks they’re a genius.
Given the S&P 500’s relatively high CAPE ratio of 30 compared to its 100-year average of 18, I would say this:
- The S&P 500 is probably expensive and therefore likely to produce materially below average total real returns (where average is around 7% per year) over the next five to ten years. If the index returned to “fair value” tomorrow it would decline by more than 40%.