How cheap is the FTSE 100?

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1 How cheap is the FTSE 100? Nine snapshots of UK equity valuation US equities are very dear right now according to most credible long-term valuation metrics. This points to disappointing returns over the coming years. The same is not true of the UK s FTSE 100, which offers decent value overall. In this report, I explore various valuation metrics for the FTSE 100 and FTSE All-Share, and their effectiveness in predicting returns over time. Dominic Picarda CFA, CMT, CAIA dominic.picarda@ft.com Recent reports and videos The S&P 500 s Road to Nowhere report Don t give up on Wall Street s uptrend video with Andrew Goldberg of JP Morgan I find that current valuations are consistent with modestly positive inflationadjusted total returns on a multi-year view. The case for Chinese equities with John Redwood of Charles Stanley Pan Asset video The challenge remains how to square the implied positive outlook for UK equities with the unpromising outlook for the US. When to buy Emerging Markets? - video

2 Forward march! Even after a five-year bull market, the FTSE 100 s forward price/earnings is barely at its long-term average. Of course, that average is not especially longterm, as the data only goes back to the mid- 1980s. And, it was clearly distorted by the tech mania of the late 1990s. The 12m forward P/E is of little use in forecasting near-term returns, however. It has explained less than 8% of subsequent annual performance over time. As an aside, analyst forecasts have generally been far too optimistic historically see lower chart. Over longer stretches, the forward P/E has been much more telling, however. On a seven-year view, current valuations are consistent with a 4.3% annualised real total return, with a very small probability of a negative outcome. Source: I/B/E/S via Datastream

3 UK stocks according to Buffett s pet tool In the late 1990s, Warren Buffett warned that Wall Street was dangerously overvalued by comparing the total capitalisation of the US stock market with the size of the US economy. As he explained in a presentation in 2001: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200% as it did in 1999 and a part of 2000 you are playing with fire. As you can see, the ratio was recently 133%. For the UK, this percentage currently stands at around 138 per cent, which is roughly the level it reached as the market peaked in The long-run average is just 75 per cent. On the face of it, this may sound worrying. On a 7-year view, it might imply a per cent annualised return, going by the past. At least for the UK, though, this indicator has historically had low predictive power. This is not altogether surprising given the flawed assumptions behind it.

4 Healthy yield, healthy capital gains Not only is the dividend yield a critical component of long-term returns, but also a good predictor of price performance. High yields often give way to capital gains and low yields to low or negative returns. Lately, the dividend yield on the FTSE 100 has been about 3.67%, almost exactly in line with the average yield since The dividend yield has been effective at foretelling returns over both shorter and longer periods, unlike many of the other metrics discussed here. It has explained around more than one-third of subsequent returns over a two-year horizon. Past experience suggests the possibility of an annualised real total return 4.3 per cent annualised over a seven-year timeframe.

5 UK equities through BEER goggles The Bond Equity Earnings Yield Ratio (BEER) which compares long-term government bond yields to the equity earnings yield is still at very low levels of around 0.54, compared to its average since 1965 of The dearness of government bonds compared to equities is often cited these days, and understandably so. However, the bond equity earnings yield ratio has almost no predictive power whatsoever. Both over short horizons of a couple of years right out to several years, the BEER has been of almost no use in explaining subsequent equity returns. The same is true of explaining the relative returns between bonds and equities. On an 8-year view, its explanatory power was a mere 13.5%. The BEER gets a bad press in many quarters and quite rightly so. There are no useful conclusions to be drawn about the outlook for UK equities from this metric, therefore.

6 Bravo, Maestro! One of my favourite tools for weighing up the FTSE 100 is the ShareMaestro model ( which takes into account forecast dividend growth, inflation, gilt yields, and riskiness. An ETF switching-strategy based on ShareMaestro s valuations would have delivered a 9.2% annualised return in the decade to 2013, against 7.9% for the best performing tracker. As of 14 March, ShareMaestro valued the FTSE 100 at 8120, some 24 per cent above its actual price. This valuation assumes fairly conservatively that the FTSE 100 will enjoy no dividend growth above inflation on a five-year view. Based on past experience, this valuation could give way to an annualised return over two years of 8.2 per cent. data. Valuation from ShareMaestro

7 Low-flying CAPE A price-to-earnings ratio that uses several years of inflation-adjusted EPS typically has more predictive power than a straightforward ratio based on a single year s trailing or forecast data. The Datastream UK total market index a noninvestable lookalike of the FTSE All-Share index is trading around 9.8 times the past decade s earnings, compared to its long-run average of (The earnings data is somewhat flawed here in that it excludes loss-makers, although its predictive power is still strong.) This hints at a possible annualised returns of 6.6% taking a seven-year view.

8 Decent value, in my book The price/book ratio has been a very reliable predictor of long-term returns for the UK market. The Datastream UK total market index a lookalike of the FTSE All-Share index - has lately been trading on around 1.8 times book value, almost exactly in line with the average since This is roughly the sort of level it was in the mid- 1980s and then again in the mid-1990s. Decent multi-year returns followed on each occasion. The 9.9% implied annualised return seems frankly somewhat optimistic, but is far from impossible. Source: Robert Shiller & Datastream. Total returns & volatility are annualised figures.

9 View from the peak Critics of CAPE often complain that it is misleading to focus on past bad earnings. The price-to-peak earnings championed by US manager John Hussman addresses this by comparing today s price with the highest earnings achieved over the last cycle. Adjusting for inflation, the FTSE 100 was lately trading on around 10 times its last peak in earnings. This valuation puts it on around the sort of levels it traded on in the late 1980s and early 1990s, both of which were obviously good times to buy equities on a medium-term view. Based on past relationships, we might expect an annualised real total return of 9.9% over the coming seven years.

10 Large-cap UK offers decent value Fundamental valuations are generally most helpful when determining the likely outlook over several years, whereas they often tell us very little about the next year or two. The accompanying tables summarise the median returns seen on UK equities over time after valuations such as today s. Taking a quick-and-dirty average of these valuations suggests the potential for modest but respectable real total returns out to Median FTSE 100 7yr return (%) Price Dividend Yield (%) Forward PE (x) ShareMaestro value/price - % Price/Peak EPS (x) Average Aside from whether past relationships will necessarily hold up in the future, the main risk to these projections comes from the US. US valuations are generally suggestive of much worse returns over the next few years. James Montier of GMO recently suggested a real total return of zero or less could be in store. Given the strong correlation between US and UK equities particular during downtrends there is surely a significant risk the FTSE struggles too. However, medium-term valuations clearly favour the UK over the US, as far as I see it. FTSE All- Share Median 7yr return (%) Price Dividend Yield (%) CAPE Price/Book MV/GNP 138% Average

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