The FTSE 100 cyclically adjusted PE ratio (FTSE 100 CAPE or PE10) – May 2011

Now that I’m back in the blogging world I’ve been catching up on all the great posts that I’ve missed over the past few months from My Blog List (full list in the right hand sidebar of the page).  Great UK based blogs such as Monevator, A Grain of Salt, Simple Living in Suffolk and UK Value Investor.  This post from ermine at Simple Living has however made me think about my cyclically adjusted PE (PE10 or CAPE) strategy and whether it is the right thing to be doing.  I am a big believer in the Keep It Simple Stupid (KISS) principle and if somebody like ermine can’t understand what I’m up to then have I made it all too complicated?

Let me try and explain my strategy in a different way to my original explanation.  I am in the camp that believes that markets are not perfectly efficient and will at times Price the market incorrectly.  One only has to think of the dot-com bubble for evidence of that.  So at times prices will be too high and at other times prices will be too low.  If you buy when prices are low then over a long period it is not unreasonable to expect you should get some out performance against a constant asset allocation and if you buy high then you could expect some under performance.  Of course you need to be careful of the effects of dividends which have a big effect on performance to name but one complication.  So how can you tell if the Price is too high or too low?

One of the simplest methods that I know is the Price-Earnings ratio (PE).  This is simply the Price of the stock/market divided by the Earnings per Share of the stock/market.  This would be a great metric if booms/busts didn’t occur and company Earnings were always consistent.  My second chart today shows a classic case of earnings not being consistent.  Correcting for the devaluation of money through inflation (CPI in this case) we can see a lovely business cycle in the blue line where Earnings in 2003 were at a low rising to a peak in 2008 before falling to a low in 2010.  From trough to peak earnings more than doubled.  Therefore if the divisor in your PE ratio is moving that wildly what hope have you got trying to figure out if prices are too high or too low using a PE ratio?  I’d say little to no chance.  So I use the method developed by Robert Shiller and instead use an average of the 10 year earnings (corrected for CPI) to try and smooth out the Earnings divisor in the PE ratio.  This is the red line in today’s second chart.  I’m the first to agree that it’s not perfect but its a lot less susceptible to wild swings caused by economic cycles.

So now that I have an inflation corrected 10 year earnings average for use as the divisor, which is relatively smooth, I can then calculate an inflation corrected Price and divide the two to give me a cyclically adjusted PE ratio (PE10 or CAPE).  My investing strategy is then very simple.  If the CAPE is higher than the long run average I want to hold less of the share market index as it is “overvalued” and if it is lower than the long run average then I want to hold more as it is “undervalued”.  This is the tactical part of my Retirement Investing Today strategy.  The rest of my strategy is simply a sensible asset allocation consisting of cash, bonds, equities (UK, Australia, International and Emerging), property and the yellow stuff (gold) with my allocation moving towards lower risk (cash, bonds) as I age.  I’d love to hear other reader’s opinions.  Does this seem sensible to you?  What methods do you use?

So that’s the theory.  Where is the FTSE 100 cyclically adjusted PE (FTSE 100 CAPE) this month?  At my last post back in December we were sitting at 13.9 against a long run average (well since 1993) of 19.7.  Today’s first chart shows that as of the 01 May 2011 we had risen to 14.4 and if I take the FTSE 100 Price at the time of writing this post (6003.92) we are at 14.2.  This is still well below the 20^th Percentile for the dataset of 16.4 while the 80^th Percentile is 23.5.  The correlation between the FTSE 100 PE10 and the Real (inflation adjusted by the CPI) FTSE 100 Price remains a strong 0.68.  In comparison the standard PE ratio is sitting at 11.6.

Finally I must point out that I am not yet using the FTSE 100 PE10 as a base for determining UK equity asset allocations and buy/sell decisions in my portfolio.  This is because I believe that a dataset only going back to 1993 is not sufficient however over time as this dataset becomes more statistically significant I will at some stage switch to it.  Today I am using the S&P 500 PE10 where I have data back to 1881 courtesy of Robert Shiller.  Not perfect but I’m relying on the close correlation of Equity markets around the world.  

As always do your own research.

Assumptions include:

-          - May 2011 price is the 01 May 2011 market close.

-          - UK CPI inflation data from April and May 2011 are estimated.