Is it time to invest in the FTSE 100?

By some measures, the FTSE 100 looks cheap, is it time to buy?

Article updated: 17 December 2019 12:00pm Author: Michael Baxter

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Look at the US and the story of the stock market over just about any timeframe you care to mention is absolutely stunning. Look at the FTSE 250, and the story is also absolutely stunning. Look at the FTSE 100 and the story is about as stunning as a wet day in the middle of winter. But does that mean it is time for the FTSE 100 to do some serious catching up?

Compare! Look at the performance of the FTSE 100 and compare with either the FTSE 250 or the S&P 500. The word pathetic may be a tad unfair, but the phrase ‘not very impressive’ does seem apt.

Since 1984, when the FTSE 100 was launched, the index is up eight-fold. The S&P 500 is up 20-fold. Since the end of 1996 when the FTSE 250 was launched, the FTSE 100 has roughly doubled, the FTSE 250 is up five-fold, and the S&P 500 has slightly more than quadrupled.

It barely seems to matter what time frame you use. Start the clock at January 2000 and you see the FTSE 100 rise by about 20 per cent. Date back to the post 2000 crash low and the index has roughly doubled. Date back to the post 2008 crash low and again it has roughly doubled.

By contrast, the FTSE 250 has trebled this century, and risen by more than 500 per cent since the post 2000 crash low and quadrupled since the 2008 crash.

The S&P 500 has doubled since the beginning of the century, and more than trebled since the 2000 and 2008 crash.

Okay there are some reasons. For one thing, the makeup of the FTSE 250 changes more significantly than the makeup of the FTSE 100, meaning more companies drop out of the index. This means the FTSE 250 has a a high level of survivor bias built in and to track the index you would need to change stocks more often.

And the FTSE 100 pays higher dividends. Allow for dividends and the underperformance of the index is not so bad but it is still poor compared to the FTSE 250 or S&P 500.

In some respects, I see an analogy between the performance of the FTSE 100 and the malaise of the UK economy. Sure the UK has a very dynamic smaller company scene and look below the stock market horizon and consider unquoted and you find a very dynamic start-up and scale-up scene. Maybe, however, the larger companies make insufficient use of technology and underinvest. Maybe their underlying problem is that many of the FTSE 100 companies operate in mature industries with modest growth potential and in some cases they operate in industries in slow decline.

Or is that harsh?

Things go in cycles and maybe at the moment, the cycle is swinging in the direction of the FTSE 100. Certainly, in this new political climate, I sense a new vigour and maybe the FTSE can be in the ascendance.

So let’s look at a few metrics.

First off there is the PE ratio. The FTSE 100 has a trailing PE ratio of around 16. I am not sure this measure means an awful lot, this reading can vary enormously — a year ago it was at just 11, two years ago at 22. The ratio varies with earnings but they can fluctuate massively and tell us little about the underlying story.

The CAPE, by on the other hand, compares valuations with the average earnings over the previous ten years; consequently this ratio is less volatile. For the FTSE 100, the CAPE is at 16 compared to around 22 for the FTSE 250. For the S&P 500, the CAPE is around 32. For the US the index is double the long run average. For the FTSE 100, the CAPE’s average is around 18, although this average was distorted by the irrational exuberance of the dotcom boom. It seems that the current CAPE for the FTSE 100 is close to par. For the FTSE 250, the current CAPE is around 22, compared to an average reading of 23. So again, it seems close to par.

Bear in mind, however, that given the fairly weak performance of the UK economy over the last ten-years, there may be potential for improvement — it depends on your view of likely long-term economic performance.

There is also a case to be made for saying valuations should be higher. Remember, the theoretical correct value of a company is its projected dividends into perpetuity discounted by a certain interest rate to give a net current value. Projected earnings is a guess, of course, but the lower the interest rate the less the rate of discount. Because interest rates are so much lower than they used to be, and ‘appear’ to be set to stay low, a higher dividend PE and CAPE could be justified.

Finally, we turn to the area where the FTSE is strong and that is dividends. The current yield for the FTSE 100 is around 4.4, compared with a 30 year average of around 3.3 per cent. By those criteria, the index is cheap. And given that dividends can be seen as an indicator of management’s confidence in a company, it is a pretty good guide.

The FTSE 250, by contrast, is paying out a dividend yield that is close to the historic average.

I leave you with one puzzle and another reason to be bullish about the FTSE 100.

The S&P 500 has been booming for years. Its performance has been extraordinary. The US economy, by contrast, has been mediocre at best. I don’t see how such a disconnect between the economy and stock market performance can continue indefinitely. There is a vague hint of a bubble about US stocks — although I would argue that new technology justifies some of the apparently wilder valuations.

The FTSE 100 seems to portray no hint of a bubble. Maybe that provides reason to be optimistic about the index.


These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.

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