The FTSE 100 Cyclically Adjusted PE Ratio (FTSE 100 CAPE or PE10) – February 2013 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.

As always before we look at the CAPE let us first look at other key FTSE 100 metrics:

• The FTSE 100 Price is currently 6,338 which is a gain of 5.2% on the 01 January 2013 Price of 6,027 and 9.5% above the 01 February 2012 Price of 5,791.
• The FTSE 100 Dividend Yield is currently 3.47% which is down against the 01 January 2013 yield of 3.64%.
• The FTSE 100 Price to Earnings (P/E) Ratio is currently 12.96.  
• 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 489.  They are down 4.6% month on month and down 11.7% year on year.  The Earnings Yield is therefore 7.7%.

So we find ourselves in an interesting situation.  Nominal Earnings are falling and have been consistently since October 2011’s Earnings of 628 yet Prices are rising.

The first chart below provides a historic view of the Real (CPI adjusted) FTSE 100 Price and the Real FTSE 100 P/E.  Look at the trend line of the Real Price.  After you strip out the effects of inflation the perceived market value is doing not much more than oscillating above and below a flat line which we are now sitting on.  The second chart provides a historic view of the Real Earnings along with a rolling Real 10 Year Earnings Average for the FTSE 100.

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As always let us now turn our attention to the FTSE 100 Cyclically Adjusted PE.  This is also shown in the first chart above.  For completeness let me also detail the usual reminders.  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 13.1 which is up against the 01 January 2013 PE10 of 12.5.
• The FTSE 100 Average PE10 is 19.1.  Assuming this is “fair value” it indicates that the FTSE 100 is 31% undervalued.  As I always say 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.
• The FTSE 100 Median PE10 = 19.3
• The FTSE 100 20th Percentile = 14.2
• The FTSE 100 80th Percentile = 23.1
• The correlation between the FTSE 100 Price and the FTSE 100 PE10 is 0.22.  This is considered a weak or low correlation.  The correlation between the FTSE 100 Real Price and the FTSE 100 PE10 is a much more impressive 0.66.  This is considered a moderate correlation bordering on a strong or high correlation.

The chart below 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 February 2008.  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 -0.46 with an R^2 of 0.15 which is considered moderate.  With the FTSE 100 PE10 at 13.1 the trendline suggests a future Nominal 5 Year Capital Gain of 54%.  In contrast the Real (inflation adjusted) 5 Year Capital Gain (not charted today) trendline implies a return of 37%.

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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: Simpler Decisions for Better Results shows a table which suggests this correlation could be as high as 0.9 which is a very strong correlation. 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 16.5 and from 1993 to present (the length of my FTSE 100 dataset) we have seen a much higher average PE10 of 26.4. 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 (16.5/26.4)x19.1=11.9. Comparing that number with today’s PE10 of 13.1 suggests an 11% over valuation compared with the 31% undervaluation presented earlier. It is this relationship that I am basing my own personal investment decisions on and so with the market continuing to become slightly over valued I am being forced to lighten up and am now targeting an allocation of 19.3% of total assets towards UK Equities as my tactical allocation compared with a nominal strategic allocation of 20% of total assets.

As always do your own research.

Assumptions include:
-    UK CPI inflation data for February 2013 is estimated.