here. That dataset is the FTSE 100 CAPE or FTSE 100 PE10 and it is the ratio of the Real (inflation adjusted) Price divided by the average Real Earnings of the last 10 years for the FTSE 100.
Why do I use the PE10 ratio? To put it simply because having analysed plenty of data I know longer believe in the Efficient Market Hypothesis which crudely states that financial markets are perfectly efficient. Instead I now believe that the market can become irrational and at times will either over or under value the market. One only has to look at the dot com crash of 2000. The CAPE is simply a method developed by Yale Professor Robert Shiller which to me is a good measure of valuing the stock market and therefore trying to find these times of irrationality. Amongst this all I am also very conscious of the old saying that the market can remain irrational longer than you can remain solvent so I guess only time will tell if my method is incredibly smart or incredibly foolish.
For full details of my methodology please start here however in simple terms from a CAPE nominal “fair” value (for the S&P it’s the long run PE10 average of 16.35 and for the ASX it’s nominally 16) I hold 30% more of that index if the CAPE is 10 lower and vice versa.
Today however, even though I hold 18% of my assets in UK Equity Index Trackers I am not using the UK FTSE 100 CAPE as my valuation method for these assets. Instead I am using the S&P 500 CAPE as a proxy and relying on high correlation. This is for a few reasons:
- The S&P500 dataset that I use, which can be picked out from the right hand side bar under the LATEST CHARTS category, goes back well over 100 years and so has seen plenty of booms and busts to make it a good market representative.
- Smithers in his book Wall Street Revalued tells me that the correlation between the US and UK stockmarkets is 0.75 which is high enough for me.
- My FTSE 100 CAPE has only been in existence for a bit over 3 weeks. I don’t yet know enough about it to shift my UK equities tactical allocation over. For starters I don’t even know what nominal value I would use to define my “fair” value.
So what’s this month’s FTSE 100 CAPE telling me? It can all be seen in my first chart but for starters the Real (inflation adjusted) FTSE 100 Price has increased a long way going from 4814 to 5397 in one month. That’s more than 10%. This has then had a big effect on the FTSE100 CAPE which has moved to 13.5 (up from 12.0 last month). The long run average remains at 20.0. The FTSE100 PE10 20 Percentile remains at 17.0 while the FTSE100 PE10 80 Percentile falls by 0.1 to 23.7. The correlation between the CAPE and the Real FTSE Price remains strong at 0.70.
My second chart shows how Real Earnings are fairing. I hypothesised with UK Value Investor when I first posted these charts whether earnings would return to around a Real 300 and whether the surge since 2004 was simply fuelled by debt and then boosted more recently by quantitative easing and excessive government deficits. Well maybe it’s already heading back towards that 300 which if prices remained as they were today would push the CAPE higher.
As always do your own research.
- August 2010 price is the 02 August 2010 market close.
- UK inflation data from July and August 2010 are estimated.