Is The UK Market Overvalued?

P/E ratio

The price-to-earnings ratio compares a company’s share price with its earnings. And in this case, takes an average for the whole stock market.

The FTSE 100 PE ratio presently stands at 15, and the FTSE 350 (an aggregation of the FTSE 100 & FTSE 250) trades on 16 times earnings, matching its long-term average. To put this in perspective, the UK stock market traded at more than 25 times earnings during the dotcom bubble (A speculative bubble in internet-based companies covering 1996–2000).

A more refined version of the PE ratio is the cyclically adjusted price to earnings ratio (CAPE), which smoothes earnings over the course of the business cycle, places the FTSE 100 on 13.5. This is again below its long-term average of 16.

However the cyclical adjusted price-earnings ratio (also known as Shiller price-earnings ratio) is by no means perfect, according to the financial economist and Reuters journalist Anatole Kaletsky. He correctly highlights that…

“Any comparison of valuations covering long periods is meaningless if it fails to take into account vast changes in technology, economic policies, interest rates, social and political structures, and taxes”.

Anatole explains that investors who followed Shiller’s methodology would have missed out on all of the gains within the last 25 years.

The Shiller price-earning ratio showed the stock market to be overvalued 97 percent of the time during these 25 years. Even during the two brief periods when the Shiller ratio was below its long-term average — in early 1990 and from November 2008 to April 200 — it never sent a clear buy signal. Instead, Shiller’s approach suggested that the valuations in 1990 and 2009 were only just below fair value — implying there was very limited upside at the beginning of two great bull markets that saw prices multiply fivefold from 1990 to 2000, and threefold from 2009 to 2014 (so far).

Therefore I would take this statistic with a pinch of salt.

Monetary Policy and Relative valuation

Monetary Policy remains very accommodative, both in Europe and across the Atlantic.

The Bank of England base rate is 0.5% and the European Central bank base rate stands at 0.05%. The Bank of England governor Mark Carney has suggested that a return of rates to the normal 5% remains unlikely in the medium term. In addition, he said that rate rises would be more limited and gradual than in the past and expects them to reach a new normal of 2.5%.

This translates into negative real interest on cash (where inflation exceeds nominal interest rates) and meagre gains on government and corporate bonds. Therefore on a relative basis, equities look attractive.

Elsewhere, inflation remains subdued and economic growth continues to pick up speed – this is good news for corporate profits. Earnings is one of two key drivers of share prices over the long-term, the other being the attractiveness of alternative asset classes.

Yield Gap

The yield gap is a common yardstick to assess whether a market is over or under valued. It is the average dividend yield in a market compared with the yield of a long-term government bond.

In this case, the FTSE 100 yields 3.4% and the FTSE 350 (aggregation of FTSE 100 and FTSE 200) yields 3.3%. By comparison the 10 year gilt year is 2.64%, this would imply that shares are undervalued. However critics would rightly point out that this method is distorted by quantitative easing and low interest rates.

Market sentiment

Finally, there is the ‘sentiment indicator’. FT investment writer John Auther’s rightly stated, “Bears need to capitulate, journalists need to stop writing articles about corrections and sentiment surveys need to grow unequivocally bullish. This is not happening yet, as this column indicates. This rally continues to be hated and distrusted, and retail investors continue to be heavily in cash”.

It reminds me of the old stockmarket maxim, ‘stockmarkets climb a wall of worry’.

This leads me to the conclusion that while the UK and developed markets are richly valued, they are not a bubble. If anything, I believe there’s a ‘bubble in the prediction of bubbles’ and many journalists make a comfortable living out of it!.

Glossary

CAPE (or Shiller PE): The ‘cyclically adjusted price to earnings’ ratio is calculated by taking an average of earnings per share (EPS) over 10 years and dividing it by the current level of the stock market.

Interesting reads

Anatole Kaletsky – Time for a ‘melt-up’: the coming global boom” November 14, 2014

Anatole Kaletsky – ‘Here’s what it will take to trigger the next stock market correction’ August 21, 2014

Anatole Kaletsky – ‘Exuberance is not always irrational July 25, 2014

Jeremy Siegel – Don’t put faith in Cape crusaders” August 19, 2013

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