As part of my investment process[1] each month I review the FTSE 100 using CAPE (Cyclically Adjusted PE) in order to project a ‘best guess’ of future returns for the UK market over the next few years.
I focus on the FTSE 100 because that’s where I do most of my investing. If you invest primarily in another index then of course you should probably be looking at CAPE for that index.
So where is the FTSE 100 today in terms of its CAPE[2] valuation, and what does that suggest about the future?
FTSE 100 CAPE slightly cheap
As I write the FTSE 100 is sitting just below its all-time high at 6,761. According to my figures that gives it a CAPE ratio of 13.3.
That’s slightly below the figure I use for CAPE’s long-term average, which is 16, and so with a CAPE value slightly below average it’s reasonable to describe the FTSE 100 as slightly cheap today.
That’s all very well and good, but so what? Cheap and expensive are woolly and subjective terms so I prefer to focus on what it could mean for future returns; and what it means for future returns is that they should be better than normal.
FTSE 100 annual return projection of 9% over the next decade
The UK stock market has returned around 5% after inflation over more than a century, so a reasonable baseline for future returns is 7% in nominal terms, assuming the Bank of England keeps inflation at 2%.
However, because of the slightly low valuation, a simple projection over the next 10 years suggests that a best guess for returns over that period would be closer to 9% a year.
Here’s a quick re-cap of where stock market returns come from:
- Dividends – with a lower than normal valuation, yields are higher than they otherwise would be and so returns from dividends are also higher. The FTSE 100 dividend yield today is about 3.5%.
- Dividend and earnings growth – CAPE has little or no impact on how quickly companies can growth their dividends and earnings. My assumption is that these grow at the historically average rate of 4% a year (i.e. 2% after inflation).
- Changes to valuations – With a lower starting valuation the change is likely to be positive rather than negative, adding to returns rather than subtracting from them. To return to a CAPE multiple…
