Here on The Value Perspective we may focus on the overarching importance of valuation in investment but we are not blind to the strange fixation people can have with ‘market levels’. In reality, the level of any market is nothing more than a number and yet, for many investors, it can be a proxy for ‘cheap’ or ‘expensive’, ‘attractive’ or ‘unattractive’.
Take the FTSE 100, the index of the UK’s 100 largest companies, which briefly broke through the 6,500 mark in the middle of March. Commentators often describe this level as ‘psychologically important’ – if for no better reason than that it starts to feel close to the index’s December 1999 all-time high of 6,930. Indeed, last month was actually the third time the FTSE 100 has passed 6,500 – in addition to 1999/2000; it also did so in the middle of 2007.
Yet, over the last 14 or so years, the market has changed markedly so that, when the FTSE 100 first reached 6,500 in 1999, companies were hugely expensive due to the 1990s bull run in general and the tech bubble in particular. When it next hit 6,500 eight years later, the market – while better value – was still expensive on the back of the so-called ‘goldilocks’ economy, heightened merger and acquisition activity and corporate profits that had reached record highs as a percentage of GDP.
What those two times had in common was the generally buoyant feeling among investors – on the whole, people felt pretty positive about the outlook for the world. Today, although we are once again back in the neighbourhood of 6,500, people are much more sanguine about the global outlook and, with regard to some of the major developed economies – most notably Europe – actually quite bearish.
Regardless of how they might see the world, however, the crucial question investors need to ask is what price are they paying? What is the valuation today? The Graham & Dodd price/earnings ratio (P/E) which, rather than referring to only one year’s profit number, uses an average of 10 years to smooth out the inevitable peaks and troughs of a market, shows the market stood on a valuation above 30x earnings in 1999 and above 25x in 2007. Today it is nearer 16x.
To put it another way, not all market highs are created equal. for more than a decade, the market has been derating so that, of all the times it has hit 6,500, this is by far the most attractive point to be investing in equities the 1999 and 2007 valuations had the market assuming profits could only continue to rise but today assumptions are much less aggressive. In 2013, the valuation is only marginally higher than its long-term average.
So is this “remortgage your house and jump into the stock market” time? Not at all – in the context of the last 100 years, today’s market valuation is slightly worse than the long-term average. What that actually means is if you are a genuine long-term investor buying equities today, then history suggests over the next decade you will make slightly less than the long-term equity return of 7% or 8% each year – 6% a year looks about right.
However, if you can find a fund manager setting out their stall to outperform the market by two percentage points a year over the next 10 years – which is what value investing says it can do – that would bring your return up to around 8% a year for the next 10 years. In today’s world, that looks like a pretty good number so what would you have to pay in return?
Uncertainty, that’s what. The price is not knowing what will happen – for example, whether the market could halve in the first year and you will only catch up in the nine years after that. Nevertheless, for investors truly able to take a long-term time horizon – and certainly compared with the last two times the market has been around the 6,500 level – there would seem a very obvious choice to be made here.