The FTSE 100 Cyclically Adjusted PE Ratio (FTSE 100 CAPE or PE10) – July 2012 Update

This is the Retirement Investing Today monthly update for the FTSE 100 Cyclically Adjusted PE (FTSE 100 CAPE).  Last month’s update can be found here.

Before we look at the CAPE let us first look at other key FTSE 100 metrics:
-    The FTSE 100 Price is currently 5,608 which is a large 6.6% above the 01 June 2012 Price of 5,260.
-    The FTSE 100 Dividend Yield is currently 3.78% having fallen back from 4.00% on the 01 June 2012.
-    The FTSE 100 Price to Earnings (P/E) Ratio is currently 10.08 which is up 7.7% since the 01 June 2012.
-    The Price and the P/E Ratio allows us to calculate the FTSE 100 As Reported Earnings (which are the last reported year’s earnings and are made up of the sum of the latest two half years earnings) as 556.

The first chart today provides a historic view of the Real (CPI adjusted) FTSE 100 Price and the Real FTSE 100 P/E.  The second chart provides a historic view of the Real Earnings along with a rolling Real 10 Year Earnings Average for the FTSE 100

Let us now turn our attention to what this post is interested in which is the FTSE 100 Cyclically Adjusted PE.  This is also shown in the first chart.  I do not use P/E ratio’s to make investment decisions from and instead use this CAPE.  This is because the P/E ratio does not take the business cycle into account which the CAPE tries to adjust for.  The method used is similar to that developed by Professor Robert Shiller for the S&P500.  The calculation is the ratio of Real (ie after inflation) FTSE 100 first possible day of the month Price to the 10 Year Real (CPI adjusted) first possible day of the month Earnings.  Unfortunately the dataset I have created only goes back to July 1993.  Therefore to get a meaningful set of numbers I have had to average in to a PE10 for the first 10 years.  What this means is that July 1994 is actually a PE1, July 1995 is a PE2 and so forth until July 2003 when we have a full FTSE 100 PE10.

The key FTSE 100 CAPE/PE10 metrics are:
-    FTSE 100 PE10 is 12.1 which is 6.2% above the 01 June 2012 PE10 of 11.4.
-    The Dataset Average PE10 is 19.3.  Assuming this is “fair value” it indicates that the FTSE 100 is 37% undervalued.  I don’t actually believe this and think that this is a function of the fact that the dataset is quite short but more on this later.
-    Dataset Median PE10 = 19.4
-    Dataset 20th Percentile = 14.7
-    Dataset 80th Percentile = 23.3

The third chart is why I use the FTSE 100 CAPE to drive a tactical portion of my Retirement Investing Today asset allocation.  It shows the relationship between the FTSE 100 PE10 and the Nominal 5 Year Capital Gains from August 1993 to June 2007.  Ideally this would be a 5 Year Total Return Chart, ie including dividends, however this dataset is not yet mature enough to allow this given my dividend data only goes back to 2006.  Even so just looking at 5 Year Nominal Capital Gains we see a correlation of -0.48 with an R^2 of 0.16.  With the FTSE 100 PE10 at 12.1 the trendline suggests a future Nominal 5 Year Capital Gain of 64%.  In contrast the Real (inflation adjusted) 5 Year Capital Gain (not charted today) trendline implies a return of 45%.

While I am making investment decisions from this FTSE 100 CAPE data I have a problem in that the dataset is quite short.  To correct for this I make a large assumption which is that there is a high level of correlation between UK Equities and International Equities.  Tim Hale in his excellent book Smarter Investing shows a table which suggests this correlation could be as high as 0.9.  Therefore if I look at my mature S&P 500 dataset it shows that from 1881 to present we have seen an average PE10 of 16.4 and from 1993 to present (the length of my FTSE 100 dataset) we have seen a much higher average PE10 of 26.6.  If I ratio these two numbers and multiply by the PE10 Average from my FTSE 100 dataset I can get a pseudo “long run” Historic FTSE 100 PE10.  Doing the maths this is (16.4/26.6)x19.3=11.9.  Comparing that number with today’s PE10 of 12.1 suggests the market is at fair value compared with the 37% undervaluation presented earlier.  It is this relationship that I am basing my own personal investment decisions on and with the market at fair value I am not targeting any tactical allocation but merely targeting an allocation based on my strategic allocation of 20% of total assets.

As always do your own research.

Assumptions include:
-    UK CPI inflation data from June and July 2012 are estimated.