Saturday, 23 May 2015

Valuing the UK Equities Market (FTSE 100) - May 2015

My investment strategy requires me to moderate my equity holdings based upon my view of current equity market values.  I run this valuation monthly for the Australian (currently targeting 15.5% of total portfolio value at current valuation vs 17% at fair value), US (as a proxy for my international equities and currently targeting 10.4% vs 15%) and UK (currently targeting 19.0% vs 20%) Equity markets.  Let’s look at the UK Equity market in more detail.

Firstly nominal values.  Between yesterday and the 1st April 2015 (“month on month”) prices are up 3.3% and since the 1st May 2014 (“year on year”) prices are also up 3.3%.

Chart of the FTSE 100 Price
Chart of the FTSE 100 Price, Click to enlarge

Regular readers will know I’m not a fan of this type of chart as:
  • the unit of measure, £’s, is being constantly devalued through inflation (although in the current market one wonders for how much longer); plus
  • Pricing should be plotted on a logarithmic scale as opposed to a linear one as by using this scale percentage changes in Price appear the same.  

So let’s correct the chart for the devaluation of the £ through inflation (I use the Consumer Price Index (CPI) here) and convert to a log chart.  This normalised chart shows that Friday’s FTSE 100 Price of 7,031 is actually still 25% below the Real high of 9,331 seen in October 2000.  We’re also still 14% below the last Real cycle high of 8,164 seen in June 2007.

Chart of the Real FTSE100 Price
Chart of the Real FTSE100 Price, Click to enlarge

FTSE 100 Earnings

As Reported Nominal Annual Earnings are currently 454 which is 9.0% lower than this time last year.  In Real terms that shrinks further to 9.3% 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
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 6.5% and can be compared with history in the chart below.

Chart of FTSE 100 Earnings Yield
Chart of FTSE 100 Earnings Yield, Click to enlarge

FTSE 100 Dividends

Dividends matter and for me they really matter as I'm trying to get investment dividends and interest (after netting off my home purchase wealth) to exceed the salary I’ll need in Early Retirement by a margin, thereby preventing the psychological problem of selling down wealth to eat.  Today nominal annual dividends for the FTSE 100 are 240 which is up 0.1% to that of a year ago which means in Real terms dividends have gone slightly backwards year on year.  As a person who is also 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
Chart of Real FTSE 100 Dividends, Click to enlarge

If we divide Dividends by Price we get the Dividend Yield which is currently 3.4% and can be compared with history below.

Chart of Real FTSE 100 Dividend Yield
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 15.5 which is higher than the 13.7 of this time last year.  Not surprising given Prices are up and Earnings are flat.

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 13.3 compared with 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
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 limited 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 -0.46 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 somebody like me who is investing for the rest of my life.

A chart showing historic CAPE to 5 Year Capital Gain is shown below.  With the CAPE at 13.3 the trendline implies a person buying today could expect a future Nominal 5 Year Capital Gain of around 52%.

Chart of the FTSE 100 CAPE versus 5 Year FTSE 100 Capital Gain
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 18.5.  Assuming this is “fair value” it indicates that the FTSE 100 could be 28% 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)x18.5=11.7.  Comparing that number with today’s PE10 of 13.1 suggests we have a 14% over valuation.  So by this metric we could be a little over valued.
  • The Dataset Median FTSE 100 PE10 is 19.0.
  • The Dataset 20th Percentile FTSE100 PE10 is 13.1.  So pretty close to the 20th percentile today.
  • The Dataset 80th Percentile FTSE100 PE10 is 22.2.  We are a long way from this level.

Making Personal Investment Decisions from this Data

As I mentioned above 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 19.0% today.

As always do your own research.

Assumptions include:
  • UK CPI inflation data for May 2015 is estimated.


  1. The FTSE may not be overvalued, but surely the S&P 500 is. If the US market u crashes, what is the likely effect on the UK and Australian markets?

    1. Using the CAPE as a valuation metric the S&P500 is some 62% over valued so I agree with you. Additionally the US bull market started in March 2009 which is 6 years ago and the previous peak was October 2007 which is 7.5 years ago. What's a typical business cycle - 7 to 10 years?

      As to what happens to the UK and Aus markets. I think the saying if the US sneezes the world catches a cold probably says it all.

  2. Hi RIT,

    Nice analysis.

    How does the Earnings yield or Dividend Yield look on the S&P500?

    "My mature S&P 500 dataset shows .... from 1993 to present (the length of my FTSE 100 dataset) we have seen a much higher average PE10 of 26.3" With 22.2 being the upper 80%, 26.3 is certainly up there based on historical numbers.

    Does worry me a little with global trackers having c.50% in the US market... must resist tinkering with allocations...

    Mr Z

    1. By my calculations I'm calling the S&P500 Earnings yield (a combination of trailing and forecast earnings) as 4.7%. Dividend yield is 1.9%.

      Just to clarify the 22.2 refers to the FTSE100 CAPE 80 percentile. The long run S&P500 CAPE 80 percentile is actually 21.2 so with it currently at 26.9 we're into exciting times.

      All IMHO of course...

  3. Hi RIT,

    Thanks for providing this helpful data and analysis. When you tactically de-allocate to a particular market, where does the balance go? Shared out between other markets, or moved into cash/bonds/other assets?

    I'm sure you're aware of data showing how correlated developed markets are. How does that inform your strategy? For me, the danger of higher CAPE valuations is the temptation to delay buying new equities, instead adding to my cash allocation which has now surpassed 25% - although history tells us this is usually a bad idea. Tactically speaking, in a borderline deflationary environment maybe it's OK?

    Thanks for your thoughts.

    1. Hi Alex

      I send the balance to cash split equally between a savings account earning 1.25% and P2P earning 4.5%. So with inflation at 0.9% and as a higher rate taxpayer I am getting a real return albeit a small one. Even with my deallocation I am however nowhere near 25% cash with my current cash allocation at 9.9%.

      In the post you can see how I use the US market valuation to adjust the UK dataset. I do the same for the Aus market. I also use the US as a proxy for my complete International Equities allocation. Otherwise I make no adjustment to account for correlations.

      Given the cash discussion I think I need to highlight one extra point with further detail in the first link in the post. This is around my broad 'equity' to 'bond' allocation. I'll be 43 this year so if I use the age in bonds rule of thumb I'd target 57% 'equities'. If I take my 5% gold and half of my 10% property from that I'd be targeting 47% equities. As I am using the CAPE valuation metric when I started on this journey I decided to adjust that rule of thumb to a 'higher risk' bonds-10 allocation which means that today with CAPE at fair value I'd be targeting 57% equities. Current CAPE valuations instead have me targeting 49.9% equities so while less than fair value holdings it's actually still above the old rule of thumb. Hope that makes sense.


  4. "targeting 49.9% equities": didn't the chap who invented the "efficient frontier" notion admit that he actually invested 50% equities, 50% bonds?

    1. I wasn't aware of that. Still working on it and will be sure to post about it at the appropriate time but when I FIRE my forever allocation will likely be 60% Equities and 40% Bonds. That will actually mean:
      - 50% Equities (5% EM's, 15% International with remainder UK/Aus)
      - 10% Commercial Property
      - 5% Gold
      - 35% Cash and Bonds (Cash will be somewhere between 1 and 3 years living expenses)

  5. Hi RIT,
    Thanks for the update. If you superimpose real earnings onto the real FTSE100 monthly price you can see that the data is unusual in that currently the monthly price seems to be going up (albeit slowly) whilst earnings are declining. This divergence between market price and earnings is also happening in Europe. The only developed market where the price seems to be underpinned by earnings growth is the US.
    I've been investing for retirement since 2004 and in that time I've grown my portfolio by 122% after charges. I weathered 2008 and decided the best way to deal with falling markets was to stay invested but it took 3 years to recover the lost ground so I've taken some profits and put them into cash so I can allow the portfolio to recover without having to sell assets. Winter's coming!

    1. Hi NI

      Looking at the US data yesterday even their earnings might also be starting to turn down. Standard and Poors have published actual earnings to December 2014 which show as 102.31 compared to last year at 100.2 so a small real increase.

      So far so good but the interesting bit is to then look at forecast earnings. Ever since I've been keeping my datasets I've found anecdotally that the analysts always seem bullish to earnings but that seems to now be turning. Q1 earnings are now 97.1% in and are predicted to be 99.25 compared with 100.85 a year ago so a bit of a fall. The interesting bit is the Q2 forecast is then 98.79 compared with 103.12 a year ago which is a fall of 4 and a bit percent.

      I'm not going to trade it and will stay the course but I am considering some popcorn. They're talking about raising interest rates in the US but I can't help but wonder why. Earnings are falling and inflation in the US is zero. We're just as likely to get more QE IMHO. As they say - interesting times - but in a way we're sort of due a down turn about now given a normal business cycle.


  6. FT100 PE10 covers 2005-2015 with a fulcrum midpoint of 2010. Looking at the PE10 v PE annual graph shows that as the 2005-2008 sharply declining PE10 years fall out the forward PE10 will rise very sharply if earnings stay constant. The only ways in which PE10 will stay at current levels a) a very sharp increase in earnings without price going up or b) a very sharp decrease in price with earnings remaining constant ... or as I see it, more likely a modest fall off in earnings causing the market to sell off very sharply and eventually overshooting to the downside.

    Why might earnings fall?
    In the UK pension autoenrollment will add 8% to employment costs by 2018 even if works net pay remains flat but as we are seeing wage growth in the private sector above inflation, and the recently announced escalating living wage this will negatively impact businesses employing lots of staff. Banks and supermarkets come to mind when looking at the FT100. Also remember that the UK is plagued by the Productivity Puzzle so don't expect this increase in employment costs to result in greater productivity ... on these figures it would have to increase by 10% just to stand still.

    The other major component of FT100 is energy and commodities both of which are sharply down already yet those companies will have based they capex for the next few years on prices twice the current level. How quickly they can adjust their businesses will determine their earnings but adjust comes at a significant cost.

    Cost of capital - Bank of England has already signalled a gradual return to more normal rates of interest over the coming 3-4 years which will impact businesses expanding using debt. If they finance by issuing equity that is normally at a discount to current price and also dilutes the equity base - both negatively impacting share prices.

    Technology - development is painfully slow. I cant think of anything I use today which I didn't have 10 years ago though it may have seen small incremental improvements e.g. 3g to 4g, touch screen v keyboard. Drugs - no new blockbusters. Aging population not addressed. Robotics still niche.

    As the opportunity cost of holding cash is low and equity looks decidedly dodgy I think I will be switching more to cash over the next couple of years.