CAPE-based valuation and forecast for the FTSE 100

21st Dec '17 by UK Value Investor

9 comments 12079 reads

In this post I look at the FTSE 100’s current CAPE (cyclically adjusted PE) valuation and then use that to make a short-term forecast for 2018 and a long-term forecast for 2027.

Is the FTSE 100 expensive?

The large-cap index has repeated hit all-time highs during 2017, and at a current price of 7,550 it sits only a few points below its highest ever closing value of 7,562.

This is why many investors think the index is expensive.

On top of that, for 20 years or so the FTSE 100 has repeatedly failed to sustainably exceed 7,000. When it’s reached that level in the past, it has subsequently fallen dramatically as the chart below shows:

5a3ba5928753fFTSE_100_value_over_20_year

This is a worrying picture. If history is anything to go by, it looks as if the FTSE 100 is probably going to collapse any moment now and plunge back below 5,000.

That is a reasonable interpretation of the past, but if we look at the past 30 years rather than the past 20 years, the picture changes dramatically:

5a3ba5e72e6e3FTSE_100_value_over_30_year

Here we can see that the “resistance” which exists at the 7,000 level is simply a temporary anomaly caused by two successive bubbles (one in tech stocks one in housing and banks).

In other words, the 7,000 level is irrelevant and what really matters is that long-term growth trend (which, in case you were wondering, is driven by a combination of inflation and real economic growth).

In terms of valuation, we can assume that the trend line is approximately “fair value” for the FTSE 100.

The chart above then clearly indicates that the FTSE 100 was expensive at the end of 1999 and 2007 (after which the index collapsed) and cheap at the end of 2002 and 2008 (after which the index skyrocketed).

Today the FTSE 100 is very close to its long-term trend line, suggesting the index is close to fair value despite also being close to its all-time high

Of course, this is just one way to analyse the market’s value and there are other, perhaps better ways.

Is the FTSE 100’s CAPE ratio high or low?

CAPE uses ten-year average earnings which are far more stable than annual earnings, and it adjusts them for inflation too. The result is a much more stable ratio than the standard PE ratio and that's why CAPE is my preferred valuation tool for…

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vik2001

21st Dec '17

great article. I think upcoming brexit will help determine the direction of the ftse, but I believe after it will shoot a lot higher to new highs.
enjoyed your post, thanks.

timarr

That's a really interesting piece of analysis. It's hard to escape the mantra of "the bull market is in its nth year, therefore a crash is coming / overdue", but this suggests that what we're seeing is actually a slow rebound from the massive undervaluation caused by the 2008 crash. Essentially markets are recovering from a near death experience rather than demonstrating irrational exuberance.

In fact, the idea that a bull market can only run for so long before a crash is an extended form of the Gambler's Fallacy - red has come up 10 times in a row, therefore it's more likely that black will come up next. Of course, at some point black will come up - but the number of previous reds is not a determining factor in that.

timarr

UK Value Investor

Thanks, appreciate the feedback. As for Brexit, I fear it will drag on for many years....

Exactly. Interesting point about the Galbler's Fallacy. It's not exactly the same because if the market goes up faster than fundamentals then it expands valuation ratios, and that in turn increases the probability that the market will go down. So in that sense the past string of "reds" can change the probability of the next spin of the wheel. However, the impact is negligible unless we're far from fair value, which we're not.

Another way of looking at it is that the FTSE 100 is getting tarred with the same brush as the US market, because they've all "gone up". But the S&P 500 has quadrupled since 2009 whereas the FTSE 100 has only doubled, and the US is expensive in CAPE terms whereas the FTSE 100 isn't.

If I run out of mince pies at Christmas I'll do a similar analysis of the S&P 500, but I don't think it will be pretty, or popular with US investors.

You're right, the analogy isn't the same but the underlying behavioural bias is identical - essentially it's a fallacious assumption about the way that mean reversion works. The problem with the read across to the US is that if the US market takes a tumble it'll drag the UK down with it, but that's the value opportunity.

I've already run out of mince pies. I may well have peaked too soon ..

timaa

the FTSE reached 7603 today, the highest ever. its broken the trend and what this tells us it could now possibly continue into a higher trend with new higher gains.

the break higher after a fairly long period of consolidation paves the way for significant upside ahead in the days/weeks/months to come

Howard Adams

A very useful article, thank you.

Regards
Howard

gus 1065

Hi John.

Thanks for an interesting article. I come to a similar conclusion (the UK markets are warm but some way from overheating) looking at the long term (1 and 5 year) moving averages and RSI as per the chart below. The three major sell offs in the past 30 years were preceded by the RSI peaking above 70 for an extended period with the severe sustained sell offs in 1999/2000 and 08/09 coming after the 12m MA crossed down through the longer 5yr MA (although bear in mind this moving average cross occurs after the sell off has already started so not really a leading indicator). We are some way from both of these inflection points notwithstanding today's closing high for the FTSE 100.

Perhaps of more concern (and as hinted in your comment #4), the chart for the S&P 500 suggests we are now into moving into "red" RSI territory. The chart for the DJI is also rising above the 70 RSI.

5a3c23c131fe5S&p_500.JPG

Notwithstanding the apparent headroom in the UK, I am concerned that we now have a more marked correlation in the global markets and that if the US does catch a cold in 2018 the UK will be affected too.

Gus.

19th Feb '18

Hi Gus, well the markets all certainly "caught a cold" at the same time in recent weeks. However, this doesn't bother me because lower prices simply mean more attractive prices and higher expected future returns (assuming it's a price correction and not a collapse of long-term future economic prospects, which IMO is far less likely and a different kettle of fish altogether).

CAPE-based valuation and forecast for the FTSE 100

Is the FTSE 100 expensive?

Is the FTSE 100’s CAPE ratio high or low?

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