Your 2014 anti-forecast - A different approach to gauging the outlook for UK equities


Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Given our well-documented mistrust of forecasting, it will come as little surprise to regular visitors to The Value Perspective that we will not be joining the crowds of investment professionals offering their take on the outlook for the coming year – or at least not in any conventional sense. We do have a view on the prospects for UK equities in 2014 – we just like to approach things a little differently.

There are plenty of commentators who will work through various factors such as GDP growth, interest rates, employment and so on before settling on one prediction or another. However, we prefer to rely as much as possible on what we can actually know in order to build up our profile of the total real return investors might reasonable expect from the UK equity market over the course of 2014.

When all is said and done, there are only three drivers of total returns at a market level – the dividend received, real earnings growth and any change in valuation – so let’s focus on those. For the sake of simplicity, we will go along with the 3.8% dividend yield currently being forecast for the UK market. It may ultimately turn out to be 3.6%, say, or 4.0% but that will not really affect our analysis.

Moving on to real earnings growth, regular readers will know we are fans of using a long-term earnings approach, as is central to the Graham & Dodd price/earnings (PE) ratio, shiller PE or what is known as the cyclically adjusted PE or ‘cape’ . These approaches all smooth out the peaks and troughs of the earnings cycle by using a 10-year rolling average earnings series – however this means the introduction of a single new year will have a relatively small influence on the overall number. as such, as the table below illustrates, the answer we are after will not be very sensitive to the level of earnings growth.

Source: Thomson Datastream, Schroders, 31 December 2013.  Dividend assumed at 3.8%. That is the current forecast dividend yield as at end December. The forecast was produced by shore capital in their biweekly research piece titled immediate income list.
Past performance is not a guide to future performance and may not be repeated.

What it is very sensitive to, however – as the table also illustrates – is the change in valuation multiple over your holding period. The UK market currently trades on a real cape of 14.3x. If the multiple were to drop to 12x, investors would lose 9% over the course of 2014. If the market were to rise to 16x, however, they would make 22%. Clearly that is quite a range of outcomes.

What therefore are the prospects for the market’s multiple? Forecasting changes in sentiment, the main driver of the market multiple, is clearly a very difficult task. Events will happen during the course of 2014 that are market-moving yet unforecastable. However, we may be able to gauge possible moves by understanding where we stand today compared with history.

The chart below shows the UK market’s valuation on a real cape basis going back to 1938 and you can see it stands at 14.3x versus a long-term average of 11.8x. Since 1980, however, the average is closer to 16x, raising the question of which average the current multiple might revert towards.

Source: Global financial data, Thomson Datastream, 31 December 2013.
Past performance is not a guide to future performance and may not be repeated.

Unfortunately The Value Perspective cannot help you here – we do not know and of course nor does anybody else. One can plausibly argue the period since 1980 was a very favourable one for equities, with low inflation and steady economic growth. One can equally argue the case that prior periods were impacted by world wars, a more parochial view on global economics and less liquid financial markets.

Irrespective, when the market is at extremes, it is easy to know what to do – when the market is very cheap or very expensive, respectively buying or selling becomes a no-brainer. Today, however, the market is broadly fair-value and the range of possible outcomes is consequently much wider.

In the past, there have in fact been 46 occasions when the market has traded at a valuation similar to today’s and in the subsequent year, as the table below illustrates, the best return was +38% and the worst was -61.5% – a spread of all but 100 percentage points. With a standard deviation of 24, one would expect two-thirds of outcomes to fall within a range of -21% to +26%, which again is of little help in forecasting the market on a one-year basis.

Source: Monthly data from 1938. Global financial data, Thomson Datastream, 31 December 2013
Past performance is not a guide to future performance and may not be repeated.

While this conclusion may not seem particularly helpful, its indecision does allow an important insight. Aggressive positioning from this point may turn out to be correct, but a significant range of outcomes is possible over the next 12 months and caution would be sensible. Furthermore, such a conclusion highlights why we do not like to talk about investing over one year – a timeframe that is too short to shelter you from the impact of market ‘noise’.

Over three, five or 10 years, though, as the table also shows, real returns from here have been in the region of 4% or 5% a year and, the further you look out, the smaller the range of likely outcomes becomes. Over 10 years, then, with a standard deviation of 5, two-thirds of outcomes have fallen within a range of an annual real return of zero to +10%.

In other words, nobody knows what will happen in this or any other single year but, if you take a 10-year perspective, the prospects of making money from today look much more reasonable. That said, those prospects may involve losing money in the shorter run so, at current valuations, it would pay not to be too bullish or too bearish in one direction or the other.


Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

Important Information:

The views and opinions displayed are those of Nick Kirrage, Andrew Lyddon, Kevin Murphy, Andrew Williams, Andrew Evans, Simon Adler, Juan Torres Rodriguez, Liam Nunn, Vera German and Roberta Barr, members of the Schroder Global Value Equity Team (the Value Perspective Team), and other independent commentators where stated.

They do not necessarily represent views expressed or reflected in other Schroders' communications, strategies or funds. The Team has expressed its own views and opinions on this website and these may change.

This article is intended to be for information purposes only and it is not intended as promotional material in any respect. Reliance should not be placed on the views and information on the website when taking individual investment and/or strategic decisions. Nothing in this article should be construed as advice. The sectors/securities shown above are for illustrative purposes only and are not to be considered a recommendation to buy/sell.

Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested.