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Where is the FTSE 100 Headed in 2012?

Wednesday, Jan 04 2012 by
7
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 using 10 year average earnings in the denominator to smoothe out the peaks and troughs of recent business cycles. He calls it the Cyclically Adjusted PE Ratio, or the CAPE for short.

According to Shiller the US market is currently on a CAPE of 20.75, which is still 31% above its median value of 15.81 over the last 140 years. An overvaluation like this has the bears baying for blood as historically the CAPE has tended to mean revert and its been in a downtrend since 2000. It’s harder to find good data for the UK market, but Richard Beddard (blogger iii) has a back of an envelope version which gives the UK CAPE of 15x earnings - a lot higher than it was at the lows of 8 or 9 in early 2009 but not nearly as intimidating as the US data.

But there has been much argument in recent months in the US as to whether Shiller’s long term PE ratio should be relevant today given the extraordinary nature of the write-offs in the last decade due to several once in a lifetime bubbles. Merrill Lynch BofA equity strategist David Bianco argues that the CAPE should be adjusted to give a current PE of 12x compared with a long run average of 15x. Forecasting a rally in the S&P 500 to 1450 in 2012 in September lost him his job 3 days later, suggesting his bosses may have had a slightly more bearish views on the market or that (as conspiracy prone blog ZeroHedge alleges) the banks are colluding to flush out weak market hands before QE3 turns them a tidy profit through Q2 2012.

Tobin’s Q is another long term valuation tool that shows US non-financial shares overvalued by 26.5%. Tobins Q, popularised in 2000 for forecasting the dotcom demise, attempts to compare the market value of companies with their replacement cost and it correlates very closely with CAPE over the long term. But again it too has its critics who state that it’s out of date given that market valuations are nowadays far more dependent on earning power than asset values and that Q ignores intangible assets such as brand values which aren’t on many balance sheets.

So now that we’ve had a look at PE ratios and asset valuations, lets look at dividends. Given the payout ratio for many UK companies is low at present many analysts believe that there ought to be room for dividends to grow in coming years. At an average yield of 3.7% most equities are paying a lot more than savers get in the bank which should provide support for shares.

An excellent book landed on my desk before Christmas called How to Value Shares and Outperform the Market by former Cazenove banker Glenn Martin. Martin takes a swing at most investing ratios like the PE as they completely ignore the prevailing economic environment. Martin rationally sets about showing how investors can create a valuation spreadsheet for the FTSE 100 incorporating the current price and yield of the FTSE and the current level of inflation and interest rates. By using the historical norm of a 2% real annual dividend growth rate the system suggests that the FTSE is 43% undervalued while using this system in reverse suggests that the market is currently expecting dividends to decline by 3.5% per year for 5 years which would be the * worst 5 year decline since 1980* - are things really that bad? Even my ‘disaster scenario’ using the system which anticipated a spike in inflation and rates and a crashing dividend payout only suggested a 10% fall for the FTSE suggesting that there’s not too much downside by these metrics. Martin’s system has a pretty good track record over the last 20 years but its dependence on the difference between bond and dividend yields reminded me of the much maligned Fed Model which was popularised during the Greenspan years.

Don’t fight the Fed?

The much derided Alan Greenspan swore by his Fed Model equity valuation technique which stated that shares were cheap when the earnings yield of equities exceeded the 10 Year Treasury Bond Yield. Currently the earnings yield far exceeds bond yields by the greatest amount since the 1950s suggesting (according this model) that investors ought to be flocking into equities - after all, if you can get a far higher return by investing in equities than in bonds without too much added risk then slowly funds ought to be reallocated back to the stock market - right? So why aren’t they? Either investors expect that rates are going to spike - which interest rate curves deny - or that investors expect earnings to collapse which is more likely. While the Fed Model did work from the late fifties until 1997, both before and since the relationship has broken down, resulting in Andrew Smithers (of Tobins Q fame) calling Greenspan’s use of the Fed Model ‘an egregious use of data mining’. Perhaps it could it be that Glenn Martin’s optimistic dividend based approach suffers from the same problem?

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Martin Zweig, the US quant investor, always had a great following in the 1980s and 1990s with a rally cry of ‘Don’t fight the Fed and Don’t fight the Tape’. He built a model that had investors buy into the stock market on dips in interest rates and get out on rises. The Greenspan put (dropping interest rates on equity market declines) further conditioned equity investors to ‘buy every dip’ for 20 years and contributed to millions of lemmings first making fortunes then losing them again in the dot com bubble precipice. But rates can’t go any lower from here. They hover near zero both in the UK and US leaving no leverage for rate dip junkies.

But Helicopter Ben Bernanke has of course come to the rescue of nervous equity investors in recent years by turning on the printing press (a process more euphemistically known as quantitative easing (QE)) . The last round of QE in 2010 launched a 30% market rally and many market insiders are expecting a similar boost from a further QE3 announcement early this year. Certainly, any more deterioration in the Eurozone would make this a near certainty leading to either a minimisation of equity downside risk or a big rally in equities if macro-economic worries stabilised. The potential of QE3 is certainly another feather in the cap of the bulls.

It’s grim out there… can sentiment possible be worse?

A good friend of mine whose opinion I value dearly thinks that all historic stock market techniques are out of the window in this environment of economic disaster with bulls and PIIGS lined up for slaughter by a slowly wielding macro axe. But I’m someone who plugs his ears to stories in memory of Odysseus - its more likely the Sirens that will lead you into the rocks than the cartographers. Macro stories are hard to quantify and making judgements based on qualitative information has been shown time and time again to lead to the poor decision making.

So what can we quantify? Sentiment for one. The best in the business is Investors Intelligence who have charted investment advisor sentiment for decades. The latest public reading of -12% is deep in the negative at its lowest level since 2009 with bearish advisors greatly exceeding bullish advisors in number. Extreme readings such as these have been shown to be reliable contrary indicators for the stock market: ’ the major rallies of the last decade have all started during periods of severely depressed investor sentiment.’.

And what of other behavioural factors? Jeremy Grantham of GMO is one of the finest market minds of recent decades and his quarterly investment letters are required reading. In his latest he discusses GMO research into what explains, but doesn’t predict, the PE Ratio. The two greatest explanatory factors for PE Ratios were found to be profit margins and inflation. Our current environment has high margins and very low inflation. In such an environment the paper suggests historically that stock markets tend to be priced in the top 5% of valuations. It should be noted that Grantham is very much a long term bear, but understands that the pull of these 2 factors give investors ‘comfort’ against the massive gravitational pull of the extremely negative macro environment. Behaviourally he suggests we could see a market rally 20% higher than its current level, whereas longer term value (given the CAPE, Tobins Q etc) points to a level far lower. Grantham preaches caution in this equity market.

The trend is your friend… or don’t fight the tape.

Furthermore in our detective tale lets look at the state of a few major technical factors and where they stand in the debate. Technical analysis without recourse to fundamentals for longer term predictions is never a wise idea as it can lead to over-optimistic forecasts (such as FTSE 10,000 by end 2012) but over the short term it can regularly turning points. In my experience, which doesn’t include much tea leaf reading, there’s only a few that have ever had much predictive value in the short to medium term, the best of which is the Coppock.

The Coppock Indicator was developed by Edwin Coppock and first published in 1962. He thought that market downturns required a period of mourning and discovered that most bereavement cycles lasted 11 to 14 months which were the periods he decided to use in his indicator. The Coppock curve has a phenomenal track record of highlighting the start of bull markets, but as a sell indicator it has a more checkered history. The state of the Coppock for most equity markets is currently a ‘wait’ after sell indicators in 2010 and it may take some time for a bull signal to be flagged again. More interestingly though both Dominic Picarda of the Investors Chronicle and Albert Edwards (Soc Gen Permabear) have written that the Coppock has signalled a ‘Killer Wave’ - effectively a double top of two sell signals in succession. Picarda ’ has identified eight killer waves in the S&P 500 over the last 83 years. All have been followed by substantial losses. The average fall following a killer wave has been 40 per cent over 20 months.’

Many technicians swear by other indicators - the 4% rule, Dow Theory, Bull Market Age, the VIX, Market breadth and so on - but all or most seem to be giving mixed signals at this current moment in time. The markets have been very volatile of late and the prevalence of false momentum signals has damaged the performance many of the best trend following/quant hedge funds. I’d be interested to hear from technicians in the comments below of anything that we should all be aware of.

As Lao Tzu would say “Stop thinking, and end your problems“…

So in our stroll through valuation, monetary, sentiment and momentum factors we have discovered much to argue over. Sensible valuation techniques seem to show the UK and US stock markets anywhere from 35% over valued to a similar amount undervalued, Technical indicators suggest the extreme possibility of a 40% decline, Sentiment and behavioural factors hint at a chance of a 20% rally while monetary factors seem to also suggest a 20% support rally waits in the wings.

In weighing up these factors I would suggest that the picture is delicately balanced with the bear side outweighing the bulls in the medium term but with the short term likelihood of the rally from the lows continuing on QE3 and sentiment relief factors. Certainly there doesn’t seem to be any margin of safety built into current prices and instability rules suggesting that range traders may finally win out. Sensible buy and hold investors might want to wait for a rout on the market to swing the edge back to the long only side , but if that doesn’t come to pass the stage is set for fleet footed long/short stock pickers to outperform.

What are your thoughts on the state of the market?


Filed Under: Valuation, Ftse, Forecasts,
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14 Comments on this Article show/hide all

Edward Croft 6th Jan '12 1 of 14
1

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.

http://www.zerohedge.com/news/bearish-investor-sentiment-nears-record-lows

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emptyend 7th Jan '12 2 of 14
2

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.

ee

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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
1

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.

ee

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UK Value Investor 7th Jan '12 5 of 14
2

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
1

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!

ee

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Edward Croft 9th Jan '12 9 of 14
1

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. 

The Folly of Forecasting Ignore All Economists, Strategists, & Analysts

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

 

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dodge1664 9th Jan '12 10 of 14
3

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
2

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.

ee

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Jackalope 10th Jan '12 13 of 14
2

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
2

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

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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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