By yesterday (26.06.13) the FTSE 100, having staged a small rally, had still fallen by near as dammit 10% from its recent closing high of 6840 on 22.05.13. In this brief note we look at the valuation of the main UK index in terms of the last 15 years and also the anatomy of its recent decline to see whether any lessons can be learned.
In terms of valuation there are of course many factors that could be taken into account; we prefer to look at fundamental valuation metrics like yield and Price/earnings ratios (P/es), in other words what we can assess, rather than what we can’t.
But first, what of the general background? The world is delicately poised economically, with a reasonable but far from robust recovery in the US, a still spluttering Europe and a very unclear situation in China. Japan is experimenting with strong monetary and fiscal stimulus to try and rejuvenate an economy which has been mired in deflation for nearly twenty years, whilst some of the resource dependent emerging economies are suffering from the collapse in commodity prices. However, whilst the US continues to recover, the balance of probabilities suggests that the global economic path should not be too rocky, despite the evident difficulties of an elegant US exit from Quantitative Easing (QE).
Aside from the economy, political issues and the potential for external shocks still abound (but they always do); the US still has not resolved its political gridlock satisfactorily, the Euro-zone may not make much progress ahead of the German election in September and, perhaps most worryingly of all, the Syrian conflict has the makings of a truly ghastly situation, with a sectarian struggle having the potential to bring in many neighbouring powers and spark an Iranian/Israeli showdown.
But returning to valuation, at the close of play on 26.06.13 the FTSE 100 (at 6165.5) was yielding 3.72% and on a P/e of 12.4. This compares with an average yield of 3.2% since 01.01.99. (this is the date from which we began collecting data). So the FTSE at these levels in trading some 14% below its average in terms of yield, which does suggest some positive upside. But what about inflation? Expectations for inflation have averaged c. 2.8% (as indicated by the yield on conventional gilts less the yield on indexed linked gilts) over the same period; this turns out to be a pretty accurate indication of actual inflation in terms of the increase in RPI. Current expectations derived from gilts are for inflation of 2.7%, so in line with the average. Thus, if dividends from FTSE 100 companies can grow by 2.7% per annum (not that demanding a figure), buying the market now should lock into a real (ie inflation adjusted) yield of 3.7%. Not spectacular perhaps, but not that bad either.
If we turn to equity yields relative to bonds, the real yield on gilts is currently 0.22% negative compared to an average of c. 1.3% positive since 01.01.99. This means that the real yield pick up from equities over gilts is 3.9%, compared to an average of 1.9%. So in terms of relative attraction to bonds, equities now look good. As regards p/e ratios (always alive to the potential distortions here from accounting rule adjustments, as we have pointed out elsewhere) the current P/e ratio of 12.4 compares to a year end average of 16.3 since 1998 and 13.2 over the last ten years. If we do accept that the economy is on a modest upward path (and earnings should roughly follow the course of economic growth) then 12.4 times does not look that expensive. There is scope for both earnings to grow and the multiple to expand.
Time to enter one big caveat here (there are probably many others); the data we have analysed and compared may be distorted in a number of ways. The period 1998 to present may not be reflective of a ‘normal’ pattern, taking in as it did the dot.com bubble, the goldilocks scenario and the financial crash. Also, with the current round of quantitative easing and the (still) exceptionally low government bond yields, we are in somewhat unchartered territory. All that having been said, from the data available to us, shares (FTSE 100) look reasonable value currently.
Does the make up of the recent decline tell us anything?
The top ten FTSE winners (the FTSE 100 fell 9.9%), were:
|Top 10 FTSE Winners (22.05.13 – 26.06.13)||Sector||% Share Price Movement|
|Whitbread||Travel & Leisure||3.1%|
|Carnival||Travel & Leisure||2.9%|
|Easyjet||Travel & Leisure||-0.5%|
The top ten FTSE losers were:
|Top 10 FTSE Losers (22.05.13 – 26.06.13)||Sector||% Share Price Movement|
|ARM Holdings||Tech Hardware||-24.3%|
The obvious points to make here are
(a) Mining and resource stocks were savaged as commodity prices fell, together with (and partly caused by) a perceived weakening in the Chinese economy.
(b) Financials (fund managers, particularly those with Far East and Emerging Market exposure such as Aberdeen) were generally weak.
(c) Some of the best performers were those stocks which had already suffered declines prior to this sell-off for specific reasons (RSA, Aviva, BSkB).
In terms of other sectors Oil and Gas outperformed (possibly because the oil majors were already thought cheap) and Engineering/Aerospace & Defence also generally fell less than the market (remembering of course that the sell off was sparked in part by the fear of removal of QE consequent on economic recovery); these sectors presumably would also see some benefit from cheaper commodity prices.
Utilities fared badly (the explanation here was that as quasi bonds, in the sense of paying a reasonable yield at lower risk than other equities, investors dumped utility stocks as long term interest rates rose) and Food & Beverages were not particularly defensive (ULVR,SAB and ABF all fell more than the overall market, but then they were all previously on quite high P/es). The insurance sector was very mixed, with RSA and AV.already hit hard previously, holding up well but PRU, SL. and OML in particular with its South African exposure, suffering badly. Travel & Leisure was probably the strongest of the sectors, perhaps indicating confidence in the consumer, although some of the stocks (WTB and WMH) may also have defensive qualities.
All in all, a fairly mixed bag; but it is a strange investment world when the weakest two equity sectors are Mining and Utilities. This world may stay strange until we get to a period when investors can focus on the positives of economic recovery rather than the negatives of QE ending and interest rates rising. Nothing here changes our view that long term investors should have a large weighting in equities at the moment.