Sunday, 3 November 2013

Valuing the FTSE 100 - November 2013

A quick glance at one of the many FTSE100 charts published by the mainstream media might start to get the average punter a little excited.

Chart of the FTSE 100 Price
Click to enlarge, Source: Yahoo Finance

Why?  Well, with the market closing at 6,735 on Friday we have now passed the previous nominal 15 June 2007 high of 6,732 following which the market proceeded to fall 48%.  We are also now only 2.8% from the nominal 30 December 1999 record high of 6,930 after which we saw falls of 52.6%.

A FTSE 100 Price of 6,732 also has us up 4.3% when compared with the 01 October 2013 Price of 6,460.  We are also up 14.9% year on year.

Am I getting excited?  In short, no.  This is for a few reasons:

  • The most important is that my investment strategy is no longer based on any form of emotion but is instead purely mechanical.  Once I made this move I found very quickly that all emotion, whether that be pessimism or optimism, when it came to economic or market news drained from me.
  • As I’ll show in this post I don’t believe that the market is actually anywhere near a new high.
  • Again, as I’ll show in this post, while I believe the market is partially overvalued it’s still only in the bottom 16% of monthly valuations since 1993.   

Let’s now run the numbers.  The last time we looked at this dataset was on the 26 June 2013.

Let’s firstly remove some of excitement by:

  • Correcting the chart for the devaluation of the £ through inflation.  For this dataset I use the Consumer Price Index (CPI) to devalue the £.
  • Plotting the Pricing on a logarithmic scale as opposed to a linear one.  By using this scale percentage changes in price appear the same.  

Looking at the chart this way reveals the FTSE 100 in a very different light.  That light shows that Friday’s FTSE 100 Price is actually still 27% below the Real high of 9,273 seen in October 2000.  We’re also still 17% below the last Real cycle high of 8,084 seen in June 2007.

Chart of the Real FTSE100 Price
Click to enlarge

FTSE 100 Earnings

As Reported Nominal Annual Earnings are a cause for concern.  They are currently 426, down from 436 a month ago and down 17.1% on this time last year.  Worse this is also a flattering result as it doesn’t allow for devaluation through inflation.  Accounting for that and Real FTSE100 Earnings are down 19.2% year on year.  Real FTSE100 Earnings are plotted in the chart below, again on a logarithmic axis, showing performance over the long term.

Chart of Real FTSE 100 Earnings
Click to enlarge

This only tells half of the Earnings story as it is an absolute number and so doesn’t help us with assessing market value.  Let’s therefore divide the nominal Earnings by the nominal Price to calculate the Earnings Yield.  Today that’s 6.3% compared with 6.7% on the 01 October 2013.  It can be compared with history in the chart below.

Chart of FTSE 100 Earnings Yield
Click to enlarge

FTSE 100 Dividends

Dividends matter.  Today annual dividends for the FTSE 100 are 232 which is the same as last month.  The Real inflation adjusted growth of FTSE 100 Dividends, which is what many long term buy and holders including myself are looking for, can be seen in the chart below.  Unfortunately I only have dividend data from 2006 but with time that will grow and it’s better than nothing.

Chart of Real FTSE 100 Dividends
Click to enlarge

If we divide Dividends by Price we get the Dividend Yield which is currently 3.5% and can be compared with history below.

Chart of Real FTSE 100 Dividend Yield
Click to enlarge

Valuing the FTSE 100 – The Price/Earnings Ratio (P/E or PE) and the Cyclically Adjusted Price/Earnings Ratio (aka PE10 or CAPE)

Many people use the FTSE 100 P/E as a valuation metric.  It’s actually nothing more than the inverse of the Earnings Yield shown above.  Today it sits at 15.8 which is up on last month’s 14.8.

Personally I prefer to use the FTSE 100 CAPE.  It was made famous by Professor Robert Shiller, who used it on the S&P 500, and it is the ratio of Real (ie after inflation) FTSE 100 Monthly Prices to 10 Year Real (ie after inflation) Average Earnings.  Today the FTSE 100 CAPE is 13.2.  It was 12.7 on the 01 October 2013 and 12.2 a year ago.

Both valuation metrics are shown in the chart below.

Chart of the FTSE 100 Cyclically Adjusted PE and FTSE 100 PE
Click to enlarge

Does it work?  Well only time will tell but what I can say is that history suggests it has some value.  If we look at a history of 5 Year Nominal Capital Gain of the FTSE 100 and compare that with the two valuation metrics we find:

  • The P/E has a correlation of -0.27 which is considered a weak or low correlation.
  • The CAPE has a correlation of -0.44 which is considered a moderate correlation.  So it’s not perfect but it’s better than P/E when looking over longish periods which suits an investor like me.

A chart showing historic CAPE to 5 Year Capital Gain is shown below.  With the CAPE at 13.2 the trendline implies a person buying today could expect a future Nominal 5 Year Capital Gain of around 59%.

Chart of the FTSE 100 CAPE versus 5 Year FTSE 100 Capital Gain
Click to enlarge

Some other CAPE metrics that may be of interest:

  • The correlation between the Nominal FTSE100 Price and the FTSE100 PE10 is 0.14.  This is considered a weak or low correlation.  The correlation between the FTSE 100 Real Price and the FTSE 100 PE10 is a much more impressive 0.64.  This is considered a moderate correlation bordering on a strong or high correlation.
  • The Dataset Average FTSE 100 PE10 is 18.9.  Assuming this is “fair value” it indicates that the FTSE 100 is 30% undervalued today.  I’m not so comfortable with this call and think that may be a function of the fact that the dataset is quite short.  I therefore rely on there being a high correlation between International Equities and UK Equities to make a correction for this short period.  My mature S&P 500 dataset shows that from 1881 to present we have seen an average PE10 of 16.5 and from 1993 to present (the length of my FTSE 100 dataset) we have seen a much higher average PE10 of 26.3.  If I ratio these two numbers and multiply by the Average FTSE 100 PE10 I get a pseudo “long run” Historic FTSE 100 PE10.  Doing the maths this is (16.5/26.3)x18.9=11.7.  Comparing that number with today’s PE10 of 13.2 suggests we have a 13% over valuation.  This is nothing like the overvaluation I think could be present in the US market (the S&P500) which I think could be as high as 46% in comparison.
  • The Dataset Median FTSE 100 PE10 is 19.3.
  • The Dataset 20th Percentile S&P 500 PE10 is 13.7.
  • The Dataset 80th Percentile S&P 500 PE10 is 22.6.

Making Personal Investment Decisions from this Data

My Retirement Investing Today Strategy drives tactical allocations from CAPE values.  It uses the FTSE 100 CAPE to set my allocation to the UK Equities portion of my portfolio.  This is strategically set at 20% of total wealth.  By adding the FTSE CAPE tactical spin on top, as detailed in the Strategy, it forces a lower tactical allocation target of 19.1% today.

As always do your own research.

Assumptions include:

  • UK CPI inflation data for October and November 2013 is estimated.


  1. A very interesting, well thought-out analysis. I have always found it strange that markets are never referred to in "real" highs and lows but just nominal. The inflation adjusted FTSE graph is very interesting for me. Thanks.

    1. Hi moneystepper

      I'm also surprised at the very limited knowledge of inflation held by the "general public". Sadly I'm not surprised that the mainstream media (MSM) don't bring it to people's attention. Inflation along with some fiscal drag etc must be one of the best stealth taxes ever invented. People can feel they're losing out but can't quite figure out how.

      Also, if the MSM embraced Real terms analysis then the result is going to be a lot less house prices/gold/equity markets reach a record high headlines. That surely would lead to less newspaper sales...

      I agree the Real FTSE 100 chart, particularly the trendline, is interesting. For the last 20 years we have done not much more than oscillate about a pretty flat trendline (increasing by a few hundred points only). Using it as the only point of analysis and one could see plenty of real price upside before the next fall.


    2. Would agree with the general view here. My own data plots the FTSE 100 against GDP at market prices which takes account of economic growth and inflation and shows a level trend over a 30 year period. This analysis suggests that the index is currently close to its 30 year norm in real terms.

      Ken Depledge

  2. As ever excellent analysis. It would be great if you could get these article into the main stream media. If anything the real FTSE chart shows how important dividends are.

    The general lack of knowledge regarding inflation held by the "general public" I think is partly down to the general poor understanding of percentages...

    ....A conversation with some colleagues regarding a recent pay rise had me dumbfounded. When I stated that the pay rise was below inflation and thus we were all a little poorer the response was basically 'eh?, how is that then, whats inflation got to with it'. When I tried to explain it the response was equally negative, even with technically minded individuals and a few have technical degrees. One said I was talking rubbish. Basically we had a 1% pay cut real terms, although the pay rise compared to what most are receiving these days was good.

    This is how governments and banks get away with 'stealing' from the masses, through ignorance.

    I recommend the book 'When money dies', its an excellent read but also quite frightening. I almost weep when I look at the interest rate on our cash savings.


    1. Hi Dylantherabbit

      I'd love for some of this to hit the MSM but unfortunately, as you allude, I'm not sure if most would understand. I'm also not selling anything and so couldn't afford to pay the media to place my 'advertisement'. If readers tweet and like the posts more it may however enable some to become more aware.

      Agree with you on When Money Dies: The Nightmare of the Weimar Hyper-Inflation. It's a top read and certainly sits within my 'library'.


  3. Well done, RIT.
    "I almost weep when I look at the interest rate on our cash savings." That may be the reason why people feel driven to invest in equities, resulting in a mild overvaluation by historical standards. I suppose a plot of (dividend yield/BoE base rate) would show some drama.

  4. These analyses of yours are invaluable -and far more objective and useful than those in the financial media or the handouts of City institutions. Thank you.


  5. Great information! Get to learn a lot. Thanks mate

  6. it is the first time i read so valuable informations.thank you