Sunday, 19 October 2014

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

Over the past couple of weeks the mainstream media have been getting all excited about recent share price falls.  As a group of people who are paid to write stuff I guess you could easily get excited by a graph like this:

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

Eyeball this short term chart and of course they’re right.  Over the past 6 or so weeks there is no denying the FTSE100 has fallen 8% or so.  Personally, as a long term investor with a mechanical investment strategy I ignore it all and simply think that markets go up and they go down.  This is more the view I’m interested in looking at:

Chart of the FTSE 100 Price since 1984
Click to enlarge, Source: Yahoo Finance

On this scale the recent pull back is a bit of noise that means nothing more than my next share purchase is likely to be made at a better valuation than it was going to be.  Providing of course that earnings hold up.  Given I’ve now mentioned the valuation word as investors let’s today spend some time valuing the FTSE 100 over the longer term rather than wasting our time on short term price movement discussions.

Firstly let’s 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.  

The normalised dataset shows that Friday’s FTSE 100 Price is actually still 32% below the Real high of 9,339 seen in October 2000.  We’re also now 23% below the last Real cycle high of 8,171 seen in June 2007.  We are therefore a long way from previous highs.

Chart of the Real FTSE100 Price
Click to enlarge

FTSE 100 Earnings

As Reported Nominal Annual Earnings are currently 496 which is 14.0% higher than this time last year.  In Real terms that shrinks a little to 12.6% 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 7.9% 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 nominal annual dividends for the FTSE 100 are 232 which is identical to that of a year ago which means in Real terms dividends have gone backwards.  As a person who is trying to build an income stream that at least matches inflation but preferably increases at a rate great than inflation this is not good news.  Real FTSE 100 Dividends 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 3.7% 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)

The FTSE 100 P/E is a popular common valuation metric.  It’s actually nothing more than the inverse of the Earnings Yield shown above.  Today it sits at 12.7 which is lower than the 14.8 of this time last year.  Of course rising Earnings and falling Prices will do that.

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 12.0 compared with 12.8 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 as a valuation metric?  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 on the other hand 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 12.0 the trendline implies a person buying today could expect a future Nominal 5 Year Capital Gain of around 61%.

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 Dataset Average FTSE 100 PE10 is 18.6.  Assuming this is “fair value” it indicates that the FTSE 100 could be 36% 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 S&P500 PE10 of 16.6 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 (16.6/26.3)x18.6=11.7.  Comparing that number with today’s PE10 of 12.0 suggests we have a 2% over valuation.  So by this metric we could be at fair value.
  • The Dataset Median FTSE 100 PE10 is 19.1.
  • The Dataset 20th Percentile S&P 500 PE10 is 13.2.  We are now even below this level.
  • The Dataset 80th Percentile S&P 500 PE10 is 22.3.  We are a long way from this level.

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 today 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 19.8% today which is pretty much a nominal holding.

As always do your own research.

Assumptions include:

  • UK CPI inflation data for October 2014 is estimated.


  1. Interesting post, I just bought a couple of shares into the dip, similar (but less sophisticated) reasoning than you.

    1. Would you be prepared to share the equities purchased and your reasoning? It might give some readers (and myself) inspiration for further research.

  2. Thanks for your insightful analysis. I always look back here for a "state of the market" temperature check.

    You mention that you have S&P 500 data back to 1881, but surely the index was only formed in 1957?

    1. Apologies, poor wording on my behalf. I'm using the US Equity dataset that has been generously published by Professor Robert Shiller as my basis. It is my understanding that this has been built using the S&P 500 from March 1957 (as you rightly mention). Into this it then splices the S&P 90 (from 1926), the S&P 233 (from 1923) and US stock data compiled by Alfred Cowles (1871 to 1930).

      The PE10 then requires 10 years of earnings data for it's first data point. Thus the 1881 reference.

  3. Excellent post. One question though. I see you use CPI as a means of establishing inflation, but I'm suspicious of anything published by Government that can be manipulated. I'd be intrigued to know if a PE10 calculated on some other inflation measure would achieve a better correlation with 5 year (or 10 year) nominal FTSE capital growth.

    1. Let's run an example and see:
      - July 1993 to September 2014 has seen the CPI increase by a factor of 1.5620. As posted this provides a CAPE to 5 Year Nominal Gain correlation of -0.47.
      - In contrast the RPI has increased by a factor of 1.8308 over the same period. This provides a correlation of -0.41. So actually worse than the CPI.

  4. I'm planning our first foray into a passive UK equity-tracker fund. You'd better be right, RIT.

    1. With 6 figures now tied up in the Vanguard UK Equity Index Fund I also hope I'm right... Of course as you know I have no idea what the future holds and instead I continue to build a diversified portfolio of assets in line with my long term strategy.

      Out of interest which UK equity index tracker are you looking to buy?

    2. I have no choice, because it's in an AVC. I do hope I'll be able to move it into a SIPP next year, or Osborne, the Great Liberator, will have lived in vain.