It's not 1999
The UK stock market has finally surpassed levels last seen 15 years ago, but shares this time do not look overpriced.
In recent weeks the FTSE 100 Index has passed the previous high reached at the tail end of the last century. Yet, there seems to be more reflection than reverie among investors. As the headline UK equity index surpassed the heights achieved in the final trading day of 1999¹, the question being asked by some is whether investors will be wary of putting more money into equity markets at current levels.
Few investors need reminding of what happened last time markets were at this level. The first day of the new millennium – which ended in a 3.8% fall for UK equities² – signalled the start of a three-year bear market, before the index eventually found its floor in mid-March 2003. There were a number of world-changing, unforeseen events during this period that contributed to the slide, most notably the 11 September 2001 terrorist attacks in the US and the build-up to the Iraq War, yet this remains possibly the most painful period for investors in a generation.
Then and now
As legendary investor Sir John Templeton opined, the four most dangerous words in investing are “This time it’s different.” So what is it about today’s market that makes it so different to 1999?
Perhaps most important for investors to consider is that the FTSE 100 Index only reflects the capital value of shares, and ignores dividend income which, over the long term, accounts for approximately two-thirds of the total return from equities. So the index level in isolation is far from the full picture. Furthermore, a closer look at the data suggests that the UK market is on a much firmer footing and does not look particularly expensive compared to 1999.
One widely acknowledged measure for analysing the value in equity markets is the price-to-earnings (P/E) ratio, calculated by dividing the current share price by the earnings per share. The lower the number, or multiple, the more value there is for investors. In 2000, the P/E ratio for the FTSE 100 was around 30; today it is around half this level – or 50% cheaper – and broadly in line with the long-term average of 15.
The crucial difference between then and now is that earnings (that is profits from the underlying businesses) have almost doubled – albeit with inevitable ups and downs – in the intervening years. Some point to shortcomings in the methodology of the P/E calculation – it typically uses earnings forecasted for the coming year and doesn’t reflect the ebb and flow over a complete business cycle – however, even on longer-term measures markets still seem to offer reasonable value. The CAPE - cyclically adjusted price-earnings - ratio uses an average of earnings over a 10-year period to smooth out these fluctuations. On this measure UK equities are still well below the long-term average.
It’s also important to appreciate that the UK market, as represented by the FTSE 100 Index, looks very different than in 1999. More than half the members have left and many no longer exist. Back then, the dotcom bubble was driven by the creation, and spectacular failure, of telecoms and technology companies. A combination of rapidly increasing stock prices, market confidence that these companies would eventually generate a profit, and huge amounts of available venture capital, created an environment in which many investors were willing to overlook traditional metrics, and common sense. Or as Warren Buffett, the veteran investor, noted, “The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs.”
Clearly no one can accurately predict where markets will go from here, but opportunities remain for investors with a longer-term outlook. Richard Peirson of AXA Framlington, lead manager of the St. James’s Place Balanced Managed Unit Trust, certainly agrees: “Taking a medium-term view – 3–5 years – I think it’s a sensible time to invest in equities. When you look back at the last peak, valuations were extreme, ridiculously overvalued. I don’t see that today.”
There is little prospect of meaningful returns from cash in the foreseeable future and, whilst nobody would argue that equity markets are at ‘bargain basement’ levels, they represent the best opportunity for long-term investors seeking income and inflation-beating returns. “Equities don’t necessarily look cheap based on long-term averages but they aren’t as expensive as when the FTSE 100 was at these levels previously. And certainly in terms of the alternatives, equities to us still look very attractive, particularly compared to government bonds,” adds Peirson.
¹ Source: Bloomberg, 24 February 2015
² Source: Bloomberg
The value of an investment with St. James's Place will be directly linked to the performance of the funds you select and the value can therefore go down as well as up. You may get back less than you invested. Equities do not have the security of capital which is characteristic of a deposit with a bank or building society.
The opinions expressed of Richard Peirson are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or St. James's Place Wealth Management.