Where is the FTSE 100 Headed in 2012?

Wednesday, Jan 04 2012 by
Where is the FTSE 100 Headed in 2012

It was Lao Tzu who stated several millenia ago that “those who have knowledge don’t predict and those who predict don’t have knowledge”, but nonetheless those that would have us believe they are the smartest minds in the market feel annually obliged to predict.

This year the average forecast from a group of 8 brokers for the FTSE 100 at year end 2012 is 5783 representing a gain of 3.8%. If those predicting such numbers don’t have knowledge and we know ourselves to be fools then perhaps we can’t do any worse by attempting to do some of the thinking ourselves. The goal of this article is to give a sweeping overview of the key drivers of share prices as understood by many of the best minds in finance and reflect on the optimal portfolio strategy for the prevailing environment.

There are four major influences on the direction of equity indices at any point in time, namely valuation, momentum, monetary and sentiment factors. While these factors may be argued over I would surmise that most additional factors (economy, earnings growth) can be bundled into one of these major categories.

Valuation- does it drive the Stock Market?

The conclusive evidence is that in the short term it doesn’t, but in the long term it does. The stock market has a tendency to gyrate over business cycles from excessive overpricing to excessive undervaluation. In order to find a value for the stock market, most investors start with the current and forecast PE ratio. Our calculations show that the median forecast PE Ratio of stocks in London stands at 13.8x with a dividend yield of 3.73% - near the long term historical norms and cheaper than the US. But profit margins are extremely high at present (at something like 9% in the US) which have historically always reverted to their long run averages - could the profits be at threat of a reversal making the PE higher than it looks? The current raft of earnings downgrades from brokers seems to back up this suspicion.

So if you can’t trust current earnings to value the market what do you do? One sage with an answer is Professor Robert Shiller, Yale Professor of Finance, who believes that using current earnings completely ignores the bigger picture of where we are in the business cycle. He calculates the current P/E ratio…

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14 Comments on this Article show/hide all

Edward Croft 6th Jan '12 1 of 14

Seems the sentiment call from Investors Intelligence I noted in the article above is seriously challenged by a divergent message from AAII. According to zerohedge AAII Bearish Sentiment -is near record lows and over 2 standard deviations below long run norms.


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emptyend 7th Jan '12 2 of 14

FWIW I think the FTSE100 will end 2012 around 6600.

From a straw poll around a pre-Christmas dining table, this seems to be considerably more optimistic than most - but my opinion is that general investor opinion is far too bearish on the stock market and indeed the general economy, at least in the UK. Margin pressures will certainly rise and some sectors (retail and perhaps banking) will remain under severe pressure but the fact is that there are not an infinite range of alternative places for people to put their money......

....and I don't think the safety trade will continue to be pursued if people are losing 3-4% real in so doing.

I'd be pretty sure there will be more volatility from Europe (and perhaps a pre-election USA) but I think 2012 will be a year in which the markets steadily become a bit more confident. If anything, I worry that 6600 may be an underestimate......

....though I don't think it will be a one-way street, despite the strong start on Day 1.

The wild card re all the above is likely to be Iran - which may well reach a critical point relatively early in the year. I could easily see an oil price spike sometime in H1, given that war games continue to be planned in the Gulf.

Other than E&P shares, where I remain very long, I'm keeping my powder dry for now in the expectation of a buying opportunity later in the year....so I guess that puts me in the category of "wait and see" in the very short term.


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Edward Croft 7th Jan '12 3 of 14

In reply to emptyend, post #2

6600 is a 20% rally which certainly seems plausible given the arguments I gave above. The long term PE (the CAPE - which everyone seems to talk about these days) suggests a longer term decline in valuations, but that could happen naturally without any significant price declines if earnings just stick around these levels for a few years. The earnings from 2001-2003 were so dismal that just replacing them with more normal earnings will have a sizeable impact on reducing the CAPE over the next few years... probably by a factor of 12-15%.

This is an old chart, but nonetheless shows the dip in earnings in the 2001 bear that will be replaced.  


The note of caution on this argument is that profit margins are at an all time high at the moment - above 9% for the S&P500.  It's always been shown that profit margins mean revert... there was a good article by John Authers in the FT that maintained the reason for the sluggishness in equity markets at the mo is predominantly due to the macro concerns, profit margins being at all time highs and the likelihood of an earnings reversion to mean given macro concerns.



That David Bianco note I referenced in the article above shows the risk premium for equities at the moment standing at something like 8%  (i.e. the amount you get paid for holding equities compared to risk free investments like 10 year bonds).  Pretty good payoff?

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emptyend 7th Jan '12 4 of 14

That David Bianco note I referenced in the article above shows the risk premium for equities at the moment standing at something like 8%  (i.e. the amount you get paid for holding equities compared to risk free investments like 10 year bonds).

...mmmm...when I did my MBA (over 25 years ago now) the risk premium for holding equities was widely understood to be around 8%. And (theory has it) it has remained at that level ever since!!

The key to maintaining earnings and margins will be pricing power. Most businesses haven't got the pricing power they have enjoyed in the last 10-20 years (thanks in large part to the internet). But I think we'll see P/E ratios for the market as a whole starting to rise soon, thanks to the lack of alternatives and the non-arrival of armageddon...so even weak or static earnings may result in higher share prices.


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UK Value Investor 7th Jan '12 5 of 14

In reply to Edward Croft, post #3

Real PE30 has been shown to correlate more closely with future returns than real PE10 (CAPE), so things like earnings dips in 2001 end up having a smaller impact and PE30 ends up as a more robust measure of value which is likely why it's more accurate. Not that anybody bothers with PE30 as it sounds crazy to look back 30 years ago, and 10 is a bit of a magic number with us decimal-digited bipeds.

As for where the market's going in 12 months I (and the rest of the human race) have absolutely no idea... but that doesn't stop it being worth a stab.

I'd say I more or less agree with emptyend. My ballpark long-term average CAPE is 15 (nice round number) which gives a value of about 6,700. If it ends up close to that I will be more shocked than anybody else.

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Edward Croft 8th Jan '12 6 of 14

In reply to emptyend, post #4

Good to see two wise heads giving us 16%+ of upside this year.  Add in 3.5% of dividends and that's a pretty good return... will hold you both to that !

On the equity risk premium - it all gets a bit academic really, but intuitively there ought to be an extra payoff of a few percent for owning stocks in the long run vs bonds given their higher volatility.   

There's a good article on the equity risk premium at Forbes http://j.mp/x6bTjz from which I've borrowed the table below and an especially good article at wikipedia http://j.mp/yJNtIM .


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emptyend 9th Jan '12 8 of 14

In reply to Edward Croft, post #6

I'd say that this list of yours proves the recent (ie last 15-20 years) tendancy towards overanalysis of historical statistics!

In "the old days" there would have been few such references - indeed I recall only that single study being in existence in the mid-1980s (it was a Barclays study, using returns since 1918 IIRC). Now we have a plethora of appoaches, driven by the ease of computing power and the ready availability of (recent!) data....coupled with the desperation of academics to justify their existences by coming up with many different hypotheses.

IMO they are all wrong! And they are all utterly irrelevant.

It is completely useless to identify from past data where the market has been. It is almost as useless to work out WHY it has been where it has been......

....as with driving a car, analysing where you have been (in minute detail) is of absolutely no help whatsoever in helping you navigate the road ahead!


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Edward Croft 9th Jan '12 9 of 14

In reply to emptyend, post #8

If you can't use the past then what's the alternative? Forecasts? Trouble is forecasters have been shown to lag reality rather than predict it. 

Check out the Folly of Forecasting by James Montier http://j.mp/wTfjiZ

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dodge1664 9th Jan '12 10 of 14

I'll take a punt on FTSE 4500 or maybe below by year end. I am bearish because
(1) we have yet to see a workable solution to the Eurozone crisis. A true fiscal union will be needed, and I don't see the Germans accepting that until we're on the brink of disaster.
(2) the US is beginning its fiscal austerity, and there is political opposition amongst Republicans to both fiscal and monetary stimulus. Without stimulus, deflationary forces will regain the upper hand, as the Keynesian macro policy errors of the last 40 years are worked off.
(3) the UK has its own set of problems and the recovery is likely to continue to be weak. Most of the growth of recent years has been built on an unsustainable boom in credit and the resultant capital misallocation still has to be worked off.
(4) the Chinese economic model is also blatantly unsustainable, and its only a question of when not if there will be an economic crisis there. Will 2012 be the year of the China crash? Perhaps.
(5) the Iran situation is a wild card. I'm not sure what will happen.

I'm a fan of the Tobins Q ratio to measure the stock market valuation, so I was pleased to see it get a mention. I have yet to hear of any criticisms of Q that actually stand up to scrutiny, although that doesn't seem to stop some people trotting them out time and again! For example the suggestion that Q is invalid because it doesn't account for brand value doesn't make any sense. One company might well sell more widgets because it has a stronger brand that its competitor, and that company would then be more valuable than it would appear to be based on tangible assets. But then its competitor would then be less valuable by a corresponding amount, so for the market in aggregate, intangibles like brand value don't matter.

The general picture I think is of a continuation of the secular bear market in stocks that began in 2000. Whilst its true that US stocks briefly exceeded their 2000 price level in 2007, they were actually much lower in real terms once you account for inflation. If we follow the pattern of previous secular bears we can expect to finish up at FTSE 3000 within a couple of years, and I'm reasonably confident that the March 2009 lows were only an intermediate market bottom. There seem to be far too many market bulls living in denial for the market bottom to have been reached already.

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Edward Croft 9th Jan '12 11 of 14

In reply to dodge1664, post #10

dodge - good comments on Tobin's Q. I find it fascinating that in the chart above Tobin's Q and Shillers CAPE create such enormously correlated conclusions while coming from different angles. I guess it shows that over a 10 year period average earnings become very correlated with growth in asset values.

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emptyend 9th Jan '12 12 of 14

In reply to dodge1664, post #10

I can't argue with any of the list of bearish points. They are all material risks. However, I see no evidence at all for this suggestion:

There seem to be far too many market bulls living in denial for the market bottom to have been reached already.

IMO sentiment and expectations are now about as universally bearish as they can possibly be. Yields in all bond markets have been chased down to record lows and indeed turned negative in a €3.9bn German bill auction today.  In view of the relative size of fixed income and equity markets (Ed probably has the figures somewhere - but the difference is huge!) it will take only a small reallocation of assets from fixed income to equities to produce a material move in equity prices.....and IMO fixed income yields are now so unattractive that I think a rally in equities is quite possible......even if several of Dodge's list of bearish points become demonstrably true.  In the meantime, they are merely a list of well-justified worries - and every quarter in which the Euro, US and UK manage to muddle through (without being undermined by a Chinese implosion or an Iranian explosion) is a quarter in which equity investors may show a profit.

My own take on Dodge's list of worries is that they are more likely to come into play in 2-3 years time, rather than the next 18 months....though certainly the Euro crisis will continue to rumble on throughout. The recent ECB action, though, has kicked the can of worms down the road for a couple of years, IMO - notwithstanding the Euro worries that will continue to create uncertainty.


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Jackalope 10th Jan '12 13 of 14

Citi predicting a 20% rise this year due to a re-rating once bearish sentiment doesn't play out as badly as predicted. But then again, I also saw the Zerohedge article saying that we're actually at a period of low bearish sentiment (who the hell were they talking to for that one I ask?!). On a macro level, I feel we're at a period of interesting tension between deflationary forces (deleveraging, austerity, budgetary cuts, asset price falls etc.) and the potential inflationary possibility of debt-monetization. Both could have interesting effects on equity prices. On balance, a reasonable allocation to cash seems a sensible strategy to me. I think the first quarter may turn out to be more optimisitc than the bear case, but we may well see this dashed on the rocks of political uncertainty, courtesy of the FIBPIGS in Europe or US budetary wrangles. On balance, I'm afraid I feel the risks remain on the downside over the next 12 months, but would love to be wrong.

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bugsmunny 11th Jan '12 14 of 14

Retrospective analysis of predictions including "professional" economists, bankers, politicians or commentators shows they are no better than chance.

And the reason is the economy is simply too complex, non-linear or chaotic to model----so in that sense it doesn't matter how many or how few indicators you look at - you can't generate a reliable prediction.

The gyrations you refer to are typical of these sorts of systems - ubiquitous in nature e.g animal populations...weather.

Of course it's easy to sound knowledgeable after the event becuase you can fit any old clap trap as an explanation - and that's what happens.

My random guess is more of the same - up and down - up and down ...


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About Edward Croft

Edward Croft

CEO at Stockopedia where I weave code, prose and investing strategies to help investors beat the stock markets. I've a background in the City and asset management but now am more interested in building great stock selection tools for the use of investors online.   Traditionally investors online have had very poor access to the best statistics, analytics and strategies for the stock market and our aim is to set that straight.  High Quality fundamental information has been prohibitively expensive in the past and often annoyingly dull. People these days don't just want to know the PE Ratio and look at a balance sheet. They expect a layer of interpretation over data, signal from noise and the ability to know at a glance whether a stock is worth investigating or not. All this is possible using great design and the insights gleaned from quantitative research.  Stockopedia is where we try to make it happen ! more »


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