I have an investment strategy that requires me to moderate my equity holdings based upon my view of current equity market values. I run this valuation monthly for the Australian, US and UK Equity markets. While I run it monthly I've just realised that I haven’t shared that analysis for the UK market for 4 months now. So without further ado let’s run the numbers for all to see.
Firstly nominal values. Between yesterday and the 2nd February 2015 (month on month) prices are up 5% and since the 3rd February 2014 (year on year) prices are up 6.3%.
Regular readers will know I'm not a fan of this type of chart as:
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 6,874 is actually still 26% below the Real high of 9,317 seen in October 2000. We’re also still 23% below the last Real cycle high of 8,152 seen in June 2007. We are therefore a long way from previous highs.
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 6.1% and can be compared with history in the chart below.
If we divide Dividends by Price we get the Dividend Yield which is currently 3.4% and can be compared with history below.
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 13.1 compared with 12.6 a year ago.
Both valuation metrics are shown in the chart below.
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:
A chart showing historic CAPE to 5 Year Capital Gain is shown below. With the CAPE at 13.1 the trendline implies a person buying today could expect a future Nominal 5 Year Capital Gain of around 54%.
Some other CAPE metrics that may be of interest:
As always do your own research.
Assumptions include:
Firstly nominal values. Between yesterday and the 2nd February 2015 (month on month) prices are up 5% and since the 3rd February 2014 (year on year) prices are up 6.3%.
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 6,874 is actually still 26% below the Real high of 9,317 seen in October 2000. We’re also still 23% below the last Real cycle high of 8,152 seen in June 2007. We are therefore a long way from previous highs.
Click to enlarge
FTSE 100 Earnings
As Reported Nominal Annual Earnings are currently 420 which is 11.1% lower than this time last year. In Real terms that shrinks further to 11.7% year on year. Real FTSE100 Earnings are plotted in the chart below, again on a logarithmic axis, showing performance over the long term.
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 6.1% and can be compared with history in the chart below.
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 235 which is up 0.4% 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.
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.
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 16.4 which is higher than the 13.7 of this time last year. Not surprising given Prices are up and Earnings are down.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 13.1 compared with 12.6 a year ago.
Both valuation metrics are shown in the chart below.
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 13.1 the trendline implies a person buying today could expect a future Nominal 5 Year Capital Gain of around 54%.
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 29% 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 12% 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 S&P 500 PE10 is 13.2. We are now even below this level.
- The Dataset 80th Percentile S&P 500 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 19.2% today.As always do your own research.
Assumptions include:
- UK CPI inflation data for January and February 2015 is estimated.
I'm persuaded. We are too light in UK equities. I shall persuade my wife to sell some of her Index-Linked Gilts and plunge into ...... um, perhaps a modest but geared investment into shares? Perhaps a little bit of Fixed Interest Gilts too, and a little property? Anyway, it's time that we diversified.
ReplyDeleteAnd then there's Abroad. Passive there, I imagine, for us. Plus some gold miners, obviously.
Oh, and on the subject of diversifying: do the earnings of P2P lending count as "interest" in terms of the up-to-£5k nil rate income tax band on interest for people with low earnings in 2015-16? I am as mindful of tax avoidance as dear Mr Moribund.
DeleteA 'geared investment into shares'. You're braver than me but then again I just don't like debt.
DeleteWhat does your asset allocation look like today? I'm always interested to put myself in others shoes and learn from them. I've never said I'm correct.
Re P2P tax. I don't know the answer to your specific question but it is my understanding that the earned interest is subject to income tax as per normal savings.
Further thought. Sounds like you have a lot of Index Linked Gilts by your comment. You must have had a fantastic 2014 investment return?
DeleteGilts have been kind to us. A silver ETF bought some time back has done well too. We also have cash in fixed term ISAs opened when interest rates were much higher. But we are horribly undiversified. But is this the wrong moment to change that?
DeleteDoes anybody really know what's going to happen? If you're convinced you need to make change but are concerned about what Mr Market is going to do you could maybe make the change over a period of months/years?
DeleteFor example I just looked back at my records. It took me 3 years to take my gold holdings from 0% to circa 5%, 4 years to take my EM's from 0% to circa 4.5% (target 5%), 3 years to take property to circa 10% etc. Not saying I'm right, it's just how my transition occurred.
Falling Earnings Yield with Negative Inflation to be announced soon is very troubling.
ReplyDeleteWe will see if EU debt purchasing can spur inflation on euro. But how it looks now central banks do not have any more mechanisms to prevent deflation and get control of economy. So let's cross fingers and hope earning can start growing again. And stubbornness in finding Greece solution is overcome.
Otherwise, get ready for negative mortgage rates :)
K.
I agree. I can't help but think Central Banks should have just butted out the first time. The over indebted would have been flushed out, plenty of hair cuts would have been taken and who knows we might have even been through it by now. What do they say - there's no free lunch - or something similar.
DeleteOn the subject of negative mortgage rates. I think I read that a Danish? bank was already there. I've just gone looking and can't seem to find it, although my Danish isn't that great. What does it mean if they start offering interest only? Property prices to infinity as you want as much debt as you can get...
We certainly live in interesting times.
Zerohegde is becoming one of the leading alternative news site. You know, not like bbc, cnn, other mainstream with tight editorial control over what public should or should not pay attention.
DeleteHere is the link http://www.zerohedge.com/news/2015-01-30/denmark-you-are-now-paid-take-out-mortgage
Negative still assumes payoff of the mortgage principal less interest. So you still have to pay mortgage, sort of principal only.The reason is the following - due to negative central bank rates, that is bank is charged to either keep the money overnight on accounts, or sell the money overnight to other banks, it is more profitable to issue a mortgage to very low risk customer where the negative rate is closer to 0 than on interbank market. Which highlights a hell of liquidity...
K.
Thanks for the link. I went to the Nordea Denmark website and can't seem to find the mortgage they are talking about.
DeletePlenty of liquidity sloshing around and the ECB is now going to add to it. Where do you think it's all going to go? European Equities to outperform?
@ dearieme. Some Investments trusts offer gearing - whereas OEICs don't.
DeleteIT's also sell at a premium or discount to NAV. A recent experience with a
poorly timed purchase of Schroder UK Growth IT - which was followed very soon after by Julie Dean ( the fund Manager ) announcing that she was leaving Schroders -resulted in a rapid widening of the discount. The very similar ex-Cazenove OEIC- also managed by Julie Dean- also fell in value but not nearly so much .
It is worth looking at an IT's own borrowing arrangements which is what usually determines it's ability to gear the fund . Highly geared funds tend to perform better in rising markets but more poorly in falling markets - ie they are more volatile than equivalent OEIC's.
@ anonymous Feb 14 and RIT. I am not an economist but I have been wondering about what freedoms individual countries do have in setting their own tax rates. Countries that are in the EZ ( eurozone) are slightly more restricted as they have to have a minimum VAT rate of 15%. But have a look at : www.vatlive.com/vat-rates/european-vat-rates/eu-vat-rates/
as there are variations in which goods ( and services ) are exempt from VAT or a subject to a reduced VAT rate .Duty on fuel , APD ,insurance policy taxes , taxes levied on house purchase , income tax rates, tax allowances,benefit payments CGT , IHT etc etc . So - there still are different
levers that Govts. can use to stimulate or suppress different parts of the economy and to aim measures at different target groups.
The problem is that , at present most EU and european countries are trying to reduce their deficits so need to maintain their tax take .
But Reaganomics showed that overrall tax takes can increase if you reduce certain taxes by the right amount and stimulate the economy- but it takes time.
Yep, it was ITs I was thinking about. We have cash in Fixed Term ISAs, and also instant access cash for forthcoming expenditures, so an obvious way to balance our portfolio (or "heap" as I call it) is to buy geared equities.
DeleteAccording to this article the Danish Central bank has cut interest rates to -0.75%, one of the retail banks have responded by charging customers to hold their money in accounts, and some mortgage holders are only paying lenders fees charged on top of regular interest payments... http://www.wsj.com/articles/danish-lenders-take-unprecedented-steps-to-combat-negative-interest-rates-1423576590
DeleteEuropean Equities performance would be side effect if the QE is successful. If it is not, then.... things could get bad...
ReplyDeleteBut I liked someone's advice - don't move and stay where you are now.
K.
"But I liked someone's advice - don't move and stay where you are now." That's easy for me right now. Physically I still have 1.5 years or so before FI beckons and I need to make some decisions on that front. Financially I'm not planning on making big changes to my portfolio other than adding to the HYP to try and increase yield as well as increasing cash holdings in preparation for a home purchase.
DeleteLucky you. Not something I can boast now.
DeleteK.
I know you recently bought Corporate Bonds and EM Equities. What other changes are you considering?
DeleteI sold US equity a bit.
ReplyDeleteP.S. I am not a fund manager, or closer to it, btw.
K.
Hi K
DeleteI was questioning changes based on your statement - "Not something I can boast now". Your comment suggests you might be able to boast also or were you thinking of something else?
Cheers
RIT
@RIT, what I've learnt is its easy to get investment fatigue and overwhelmed with diversification and different strategies. I've simplified my portfolio using ISAs into 21 blue chip UK shares, 21 blue chip USA shares and VUKE, VHYL. That's it, this is what I will stick with. I only care about dividends and this portfolio will cover all my living expenses next year. I'm not interested in capital appreciation or depreciation (I kind of do ... but you know what I mean). The S & P 500 and FTSE receive 50% of earning from overseas. I don't think you need European, Asia Pac, EM diversification. The only decision I need to make is what do with my substantial SIPP, currently its invested in 4 high yield shares. There come a time when you've done enough analysis, just let the portfolio sail, generate the income and start living.
ReplyDeleteThanks for sharing Anon. Another example of another approach for us all to think about. If I'm interpreting correctly though that means you have a 100% equity portfolio. For me personally that is out there from a risk perspective plus also I've seen research (the Bernstein book under my Books That Helped Tab primarily) that suggests there is some free lunch from even a small helping of other asset classes. Have I interpreted correctly or do you have a DB pension or similar also?
Delete"There come a time when you've done enough analysis, just let the portfolio sail, generate the income and start living." But what would I do for a hobby then? :-)
@RIT, I have a mortgage free house and substantial cash savings which act as my bond anchor. I also have a substantial SIPP consisting of only 4 stocks (RDSB, BP, GSK, BHP) purchased when the market hated these shares. This SIPP has a blended yield of 6% and I'm waiting for significant capital appreciation when the shares rerate and may then convert this into bonds. Some of the USA shares have been generating increasing dividends for 50+ years, they are compounding machines. A selection of 30-40 highest quality shares means you can live off the dividend income forever, so does it really matter if you are 100% equity ? During the 2008/2009 crisis the majority of these companies continued to pay dividends. They are compounding machines. I want to be like the Old Southern Gentlemen who lives off his income, NEVER sell your capital, that's akin to cutting off your right arm, that's why I don't agree with all this 3% or 4% SWR rates.
ReplyDelete"I want to be like the Old Southern Gentlemen who lives off his income, NEVER sell your capital, that's akin to cutting off your right arm". This is exactly my thoughts and what I'm targeting before calling myself FI. Psychologically I can imagine how difficult it would be to be in the middle of a down turn and then be forced to sell down assets to eat.
Delete"...that's why I don't agree with all this 3% or 4% SWR rates." I'm with you on the first half of the sentence but I still feel SWR has some miles and the two are not mutually exclusive. My current research says that 2.5% after my investment expenses is right for me.
It will be interesting to see how our two portfolios perform going forwards. I tend to publish my returns quarterly.
@RIT, this is my equally weighted portfolio, the anchor has been drawn, this 42 manned crew ship will sail by itself ....
ReplyDeleteUK: ADN, AV, AZN,, BAE, BHP, BLND, BP, DGE, GSK, HSBA, IMT, NG, PSON, RDSB, RIO, RR, SAB, SSE, ULVR, UU, VOD
USA: BAX, CVX, EMR, GE, GIS, HCP, IBM, JNJ, KMI, KMB, KO, KRFT, LMT, MCD, O, PEP, PM, PG, SO, T, XOM
ETFs: VHYL, VUKE
Eyeballing the UK portion and it's a stamp collection that is fully on my watch list. That said ethically while on my watch list I'm not sure I'll ever be able to pull the trigger on IMT or BAE. We also share plenty in the form of AZN, BLT (BHP), BP, GSK, HSBA, PSON, RDSB, SSE and VOD. Many others I'd like to buy but they look a little pricey right now.
DeleteThanks for sharing.
As always thanks for your hard work in keeping these charts up to date and sharing with us - I'm very grateful.
ReplyDeleteHow do you see the composition of the index affecting one's assessment of the CAPE10? I.e. the balance of the index as between sectors has changed. I have read that what is a 'cheap' PE in one sector may not be cheap in another.
ReplyDeleteWhat an excellent post. I have been looking for something along these lines for ages but was unable to find it (or find the time to put one together myself). John over at UK Value Investor directed me here for which I am very, very happy!
ReplyDeleteThanks for putting it together. I am still unsure how I missed it whilst going through your site!