Saturday 7 June 2014

Valuing the UK Stock Market (FTSE 100) - June 2014

When nominal charts of the FTSE100 start looking like this:

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

Which are showing us being within 1% of the nominal 30 December 1999 record high of 6930, the chatter in the mainstream media about the potential to reach new highs kicks off.

So what do I think about the potential to reach new highs?  Well I don’t actually even waste brain power considering it for a few reasons:

  • The most important is that my investment strategy is no longer based on any form of emotion but is instead now purely mechanical.  This was done because early on in my DIY investing career I realised that no matter how much energy I expended I actually had no idea whether the market was going to go up, down or sideways.  A lot of people out there do claim to know but from what I can see most of these seem to make their money by commenting on it in the media, writing books on the topic or by selling investing newsletters.  If they really do know why are they expending energy doing this rather than making a fortune trading with this great knowledge?  I really do now believe that unless you have inside knowledge, which you can’t profit on legally, then they are all actually just like me.  They have no idea. 
  • As I’ll show in this post the market is actually nowhere near a new high.
  • Again, as I’ll show in this post, while I believe the market is slightly overvalued it’s still only in the bottom 17% of monthly valuations since 1993.   

Let’s run the numbers.  Firstly we’ll remove the excitement and normalise the data 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 9,367 seen in October 2000.  We’re also still 16% below the last Real cycle high of 8,196 seen in June 2007.

Chart of the Real FTSE100 Price
Click to enlarge

FTSE 100 Earnings

As Reported Nominal Annual Earnings are currently 484, down from 498 a month ago and down 3.4% 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 5.7% 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 7.1% and 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 240.  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 14.2 which is up on last year’s 13.0.

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 13.1.  It was also 13.1 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 -0.32 which is considered a weak to moderate correlation.
  • The CAPE has a correlation of -0.47 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 13.1 the trendline implies a person buying today could expect a future Nominal 5 Year Capital Gain of around 58%.

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 0.08.  This is considered a weak to zero correlation.  The correlation between the FTSE 100 Real Price and the FTSE 100 PE10 is a much more impressive 0.62.  This is considered a moderate to strong correlation.
  • The Dataset Average FTSE 100 PE10 is 18.7.  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)x18.7=11.8.  Comparing that number with today’s PE10 of 13.1 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 54% in comparison.
  • The Dataset Median FTSE 100 PE10 is 19.1.
  • The Dataset 20th Percentile S&P 500 PE10 is 13.4.
  • The Dataset 80th Percentile S&P 500 PE10 is 22.4.

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 19.2% today.

As always do your own research.

Assumptions include:

  • UK CPI inflation data for May and June 2014 is estimated.


  1. There is, I suspect, a world of difference between being someone who is socking money away each month, saving for retirement, and someone who is retired, wondering what to do with his lump of money.

    The former can grin at market declines, thinking "Oh good, shares are better value now".

    The latter winces, thinking "God, can I keep me and my widow out of Queer Street?"

    My solution has been to have lots of capital in Cash ISAs that yield more than inflation. But their fixed terms are ending. What to do next? Maybe a mix of Equities, short-maturity fixed-interest Gilts, cash at interest-bearing current accounts, and some Precious Metals? It's Harry Browne hour, except that my gilts would be short-maturity, not long.

    There is a counter-argument. Much of our income is from index-linked Final Salary pensions. It follows that one of our major risks is that the pension schemes go phut; even if the rescue scheme can afford to deal with them, most of the index-linking would be removed. Now, how can we hedge against that?

  2. Nice analysis. Overvaluation is not a concern if company earnings catch up. Your figures for Nominal Annual Earnings "currently 484, down from 498" are useful here and suggest real caution.

    My only question - If you prefer PE10 to PE because the correlation is better (-0.47 versus the weak to mederate -0.32), how can you justify taking any firm conclusion from the last graph where the correlation is 0.2219!!! The CAPE to 5 year capital gain graph shows very poor correlation with a very large set of outliers (top-middle). How can you explain these outliers?

  3. If you think the S&P is overvalued by 54%, then presumably you think it will revert back and so fall? If the S&P does fall quite a bit, don't you think it will take the FTSE down with it, in a general market decline? So whether or not the FTSE is overvalued or undervalued now, there could be better FTSE value ahead?

  4. Thanks for this very helpful analysis. I'd be interested to know how you've calculated the FTSE100 PE10 (e.g. median, or mean of individual constituents). My data for the whole FTSE All Share market shows a median PE10 of 19 at 30 June.