The FTSE 100 and S&P 500 are trading at very different valuation levels.
US and UK large-cap investors have had very different experiences since the crash of 2009. Over these 12 years, the FTSE 100 more or less doubled, going from a low of around 3,500 to a pre-pandemic high of just over 7,500.
The S&P 500 did better. Much better. It went from its financial crisis low of just under 700 to a pre-pandemic high of almost 3,400, giving investors a near 400% gain.
And then, of course, COVID-19 reared its ugly head and both markets crashed hard. However, the crash was incredibly short-lived and both indices bounced back with surprising speed.
After a near-vertical decline in February 2020, from just over 7,000 to just below 5,000 in barely a couple of weeks, the FTSE 100 has since recovered almost all of its lost ground and now sits slightly above 7,000 once again. That’s a nice robust recovery, but it pales into insignificance next to the S&P 500.
“The US index seems to have tied a rocket to its back and lit the fuse”
That may seem like hyperbole, but following the 2020 crash, when the S&P 500 fell from 3,400 to 2,200 in a few weeks, the US index seems to have tied a rocket to its back and lit the fuse. It recovered every inch of ground lost by September and at the time of writing it has reached a new all-time high just above 4,200.
So, despite the fact that the world is still in the middle of a pandemic and that most economies around the globe are struggling to get on top of this virus, the S&P 500 is now 25% above where it was before the pandemic.
Of course, bulls will say that the US tech titans which dominate the S&P 500 have actually benefitted from the pandemic, and they have. But bears will say that a combination of lockdowns, ‘free’ trading apps and social media have created a perfect storm of newbie speculators who have only seen the market go up during their adult lives.
But whether you’re a bull or a bear, a 25% gain for the S&P 500 in barely a year and more than 500% gain since 2009 should start to raise some eyebrows, especially if you take a look at the S&P 500’s valuation according to its CAPE ratio.
If you’re not familiar with CAPE, then here’s a quick summary: it’s a PE ratio which uses inflation adjusted 10-year average earnings instead of last year’s earnings. Average earnings are more stable than earnings in a single year and they’re more closely linked to a company or index’s intrinsic or fair value.
Turning back to the FTSE 100, it had an average CAPE of 18 over the past 30 years, but that may be too high, because the past 30 years includes the dot-com bubble. I prefer to use a more cautious average of 16, as I think that’s likely to be closer to the true long-term average.
Today the FTSE 100’s CAPE ratio is 15.8. That’s close to its long-term average and it’s near the middle of its range over the past 30 years, which stretches from 10 in the 2009 crash to 34 in the dot-com bubble. Given that CAPE isn’t very high or low, I think it’s reasonable to say that the FTSE 100 is probably close to fair value and isn’t obviously expensive or cheap.
For the S&P 500 the story is very different. Over the past 30 years its CAPE averaged 24, while over the past 100 years it averaged 18.
As with the FTSE 100 CAPE, the S&P 500 CAPE has been higher in recent years, thanks to high valuations in the dot-com bubble, the credit bubble of the mid-2000s and the current period of optimism.
With the S&P 500 close to 4,200 today, its CAPE ratio is 37. That’s more than double its 100-year average of 18 and well above its 30-year average of 24.
Again, bulls will say that this is reasonable given the dominance and continued growth of the US tech titans, but it should still cause an eyebrow to be raised.
For example, let’s assume US inflation stays at the Federal Reserve target of 2% over the next 10 years and that the S&P 500’s earnings grow by their average of 4% per year above inflation.
Under those assumptions, here are three possible scenarios: Bubble 2031: CAPE is 36 (twice the average) and the S&P 500 is at 7,200, about 70% above where it is today. Benign 2031: CAPE is 18 (average) and the index is at 3,600, around 15% below where it is today. Depression 2031: CAPE is 9 (half the average) and the S&P 500 is at 1,800, a massive 60% below where it is today.
“To me it looks as if the odds are against the S&P 500 performing well over the next 10 years or so”
Even if we assume that CAPE is 24 in 2031, which is the average of the past 30 years, the index still ends up at 4,800, barely 15% above where it is today. To me it looks as if the odds are against the S&P 500 performing well over the next 10 years or so. History strongly suggests that returns from such high valuations are either weak or terrible, and no previous bubble has avoided a large and usually multi-year bear market.
Let’s see how the FTSE 100 does under similar assumptions (2% inflation and 2% real earnings growth, in line with historic norms).
Under those assumptions, here are those same three scenarios: Bubble 2031: CAPE is 32 (double the average) and the FTSE 100 is at 22,400, about 200% above where it is today. Benign 2031: CAPE is 16 (average) so the index is at 11,200, about 60% above today’s price. Depression 2031: CAPE is 8 (half the average), so the FTSE 100 would fall to 5,600, or about 20% below today’s level.
Unlike the S&P 500, the FTSE 100’s future seems to be mostly skewed to the upside. There is a small chance of a 200% gain or more, a far bigger chance we’ll see returns of around 50-100% over a decade and a small chance the FTSE 100 will see a small decline.
So, although the S&P 500 is the hot index right now, I think there’s a good chance the FTSE 100 could outperform it over the next decade.
