Saturday, 6 November 2010

Happy birthday to me and the FTSE 100 cyclically adjusted PE ratio – November 2010

Since my last post I’ve aged one more year. This has meant that in addition to spending enjoyable time with family and having one too many pieces of birthday cake I’ve also taken time out to assess the level of risk I want to hold in my low charge portfolio. As I’ve explained many times in the past (start here if you’d like to know the basics of my strategy) ( ) my strategy is largely mechanical and centred around a basic strategic asset allocation of 28% ‘low’ risk (bonds) assets and 72% ‘high’ risk (equities) assets. This was then modified to add additional asset classes and to clarify exactly what I mean by bonds and equities. At the end of this process I ended up with a target strategic allocation of:

22% Bonds (Cash which is mainly my emergency fund, Index Linked Gilts, Index Linked Savings Certificates)
21% Australian Equities (ASX 200)
21% United Kingdom Equities (FTSE All Share)
15% International Equities (40% US, 40% EU, 20% Japan)
5% Emerging Markets Equities (MSCI Emerging Market TRN Index)
10% Property (Listed Euro Property and UK Commercial)
5% Commodities (Gold)

In line with my mechanical investing strategy to remove all emotion from investing my yearly de-risking is also simple and mechanical. I’m simply removing 1% from high risk assets (0.5% from Australia Equities and 0.5% from UK Equities) to give target nominal strategic asset allocations of 20.5% respectively. I’m then adding that 1% to Bonds (Index Linked Gilts or Index Linked Savings Certificates which unfortunately aren’t currently available). Of course I will continue to be overweight or underweight against these equity allocations depending on the value of the relevant cyclically adjusted PE ratios. This is in line with my mechanical tactical asset allocation strategy.

Speaking of cyclically adjusted PE ratios let’s take a look at the latest FTSE 100 cyclically adjusted PE ratio (CAPE or PE10).

The first chart shows that with the nominal FTSE 100 price moving from 5592.9 (01 October) to 5694.6 (01 November), an increase of 1.8%, over the month the PE10 ratio has also risen from 13.9 to 14.1. This is still well below the FTSE 100 PE10 20 Percentile for this dataset of 16.9 while the 80 Percentile is 23.7. The long run average is still 19.9 for the dataset shown in the chart. The correlation between the PE10 and the Real (inflation adjusted by the CPI) FTSE Price remains a strong 0.70. In comparison the bog standard P/E ratio is currently sitting at 14.5, up from 14.5 last month.

My second chart shows Real Annual Earnings. In a month they have decreased from 399.5 to 394.1. This is however well up on 1 year ago when we were at 299.0. The big question for me though is whether these ‘high’ rates of around 400 are sustainable. For me 300 looks to be about the right level of real earnings if you ignore the credit fuelled excesses of the past few years.

As always do your own research.

Assumptions include:
- November 2010 price is the 01 November 2010 market close.
- UK inflation data from October and November 2010 are estimated.


  1. You raise the question of whether real earnings might surrender their gains & revert to the mean.
    I'm no economist but...
    I would expect corporate earnings to rise in line with the GDP. So if the economy grows, then so will corporate earnings. (I guess there would be disclaimers about public/private balance in the economy & probably other things I cannot think of off hand.)

  2. Hi Tony

    I'll be contrarian and disagree with you, replying with a couple of questions, to encourage some debate:
    - Why does there always have to be growth? I think in this world we have maybe become obsessed with the term but I can't understand why it always has to be the case. If population growth stops or if the cheap energy world we live in stops, to give 2 examples, then so does the growth. I think the world is struggling to hang on to the abuse we are giving it today (and no I'm not an environmentalist but do believe in sustainability) and more population growth etc is going to tip her over the edge.
    - Why do the Corporate earnings of the FTSE 100 companies have to capture a fair proportion of the worlds growth? We have seen the emergence of China taking plenty of market share from traditional economies/companies. I fully expect to see countries like Vietnam and some of the African countries also have a go in the near future.

    Finally lets follow your methodology and say earnings grow in direct proportion to GDP. The GDP change will take a long time to have an effect. An annual GDP change of say 2% would take around 36 years to then double earnings. That is a long time. If fair earnings today are 300 as I mention and earnings today are at 400 then you are looking at 15 years or so to have that 400 as fair earnings assuming 2% growth.

    Hope that all made sense. I seem to be in rambling mode today. What do you think?