Is the FTSE Under OR OVERvalued?

2012 has been yet another tough for those who like to trade the FTSE. The blue chip index is up just 5% YTD and has lagged the US markets in particular that have produced double digit returns so far. Much to the chagrin of trend followers (and in particular the likes of Man Group with their continually underperforming AHL fund), there has been no real trend to get onto witht he FTSE for nearly 2 years now with sharp moves primarily to the downside followed by reactive rallies and then grinds higher – “Zig & Zag” FTSE is perhaps a more appropriate name!

FTSE 10 Year chart

Investors remain nervous about Europe, China and in the U.S. of course regarding the so called  “Fiscal Cliff”. It seems one day all is fine and then reality is turned upside down and traders are fooled once more – good for spread bet firms but not for spread bettors who constantly get whipsawed! Volatility is often good for spread betters but this type of environment is really tough to trade, unless you are a nimble “swing” trader.

In terms of the domestic economy, the year has also been tough for the UK with GDP falling into the 2nd quarter and in fact sufficiently so be described as being back in recession. Fortunately , GDP recovered showing growth of 1.0% over the last quarter. George Osborne certainly has tough days ahead to put the British economy back on track even with his new prize Governor of the BoE Mark Carney, what with Peripheral Europe threatening to derail the whole Euro-land and a game of battleships being played between the Democrats and Republicans in the U.S. It is hard to second guess the FTSE’s next move in this environment and so a look at the valuation of the index relative to history could provide us some clues as to whether we should trade off the bull or bear bias.

The medium-long term picture allows us to look through the current geopolitical turmoil. Valuations are of course the ultimate driver for stock prices. To help us in our analysis, we have collected some third-party data from Fidelity who have carried put some interesting research regarding the correlation between the price-earnings ratio of the FTSE and subsequent returns from a given PE level.

The table below shows how the FTSE All-Share fared in the years following an average price earnings ratio valuation. The percent return is the annual return acheived.

As expected, the lower the P/E, the higher the rise in the subsequent years. As the ratio is a measure of valuation, it makes sense that over a medium term range, the more undervalued a market, is the more potential there is for growth in stock prices. When the P/E is above 17 in particular, the data shows that the potential for rises in stock prices has been historically low or even negative (certainly in real terms).

After checking the above table, one question remains: where does the market currently sit in terms of P/E?

At current levels, the FTSE 100 is trading on a current PE of just over 11 times and the FTSE All-Share around 12. According to the above table, when the FTSE All-Share was trading with a P/E ratio between 11-14, it rose an average of 8% per year in the following five years and an average of 7% in a period of ten years. That is encouraging!

Current dividend yields for FTSE All-Share and FTSE 100 are 3.64% and 3.77” respectively, values that are historically high and so adding weight to the undervaluation theory. Finally we also have to look at Government bonds. The benchmark 10-year Gilt is currently yielding around 1.80%. At these levels, many have to look elsewhere in a desperate attempt to get some upside potential as the Gilt would recompense you for inflation.

If it is difficult to guess what will happen during the next few months but what we can state is that FTSE is currently historically undervalued and the odds of a rise over the next five to ten years are high. In short, any deep sell offs on Euro-zone and fiscal cliff fears that are not likely to materially impact the medium term earnings picture should, in our opinion, be used to enter medium term long trades, just like we have been doing in Japan.