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Grand slammed

It’s been a difficult time to lose money investing in equities recently.

Global indices have shrugged off any perceived risks and since the UK referendum the FTSE has returned close to 19%, the S&P 500 and Nikkei 14% and 20% respectively. Indices including the FTSE 100 have been breaking through previous peaks to post new highs. The MSCI World index that tracks the stocks of global developed markets also posted a new high and in dollar terms it has gained $6tn since the Trump election.  Just to give you an idea that’s equivalent to total GDP of the UK and Germany combined!

In the US we recently saw the so called Grand Slam as the major domestic indices peaked simultaneously. The S&P 500, NASDAQ, Russell 2000 and Dow Jones closed at their respective highest levels. Whilst not unknown, this is a feat achieved only 61 times since 1990 and until November last year one that had not been achieved this millennium.

Focusing a little closer to home, what about the UK version of this grand slam?

Since 1985 the FTSE 100, 250 and small cap indices have closed at their respective peaks 107 times, 6 times this millennium. 13 of the past 15 occurrences have seen the FTSE 100 fall in the subsequent year after reaching their peaks. The two that have not seen a 12 month fall actually happened this year so obviously they haven’t had a full year performance data.  Only 10 of the past 15 occurrences have more than a one year’s subsequent return data, each of these saw negative annualised returns for the 1-5 year period following a tri-market peak.

A closer look at these periods and it is apparent they happened in the final year of the tech rally, in fact during the most exuberant phase between November 1999 and early January 2000.  Given the FTSE 100 took 15 years to recover in price terms these results are unsurprising.

Should we be worried when markets are at all time highs?

If you look over the entire history of ‘UK grand slams’, on average you would return 5% if you invested at the point of the peak. The median return is just 1%.  Given the long term annual return of the FTSE 100 is 10% if we looked at this alone it’s not looking like a particularly good time to buy into markets.

Then again, each story has two sides and historically we have seen subsequent annual returns range between 38% and -20%.

However, share prices don’t look at the market level when deciding to go up or down.  Over the long run share price is derived from the earnings and profitability of the company. Performance is a little more complicated, it takes into consideration current share price and future share price. You can buy the most profitable company in the world but if you pay too much for the earnings you will likely lose out in the long run.

A popular metric used to measure how much you are paying for the earnings is the price earnings ratio (PE). This is calculated by taking the price you pay divided by company profits.

Below is the scatter chart showing the subsequent annual return of the FTSE 100 compared to the historic PE for each ‘UK grand slam’ since 1994 (since FTSE PE has been recorded).  The higher the PE the more you are paying for the earnings, it follows the more you pay for earnings the lower the returns you can expect to receive, or the greater the chance of losing.  

chart1.PNGEach marker represents each 'UK Grand Slam' since 1994, it reflects the PE and subsequent 1 year return of the FTSE 100

What we essentially have here is a chart of a very small subset of all annual FTSE returns compared to historic PE.  This relationship is borne out through the entire history, if you buy something cheap you have a greater chance of making a greater return.  Currently the FTSE 100 historic PE is about 31 which is very expensive relative to history. That doesn’t bode well for stocks over the next 12 months if this pattern is repeated.

When evaluating equities we use a number of measures including PE to assess attractiveness.  Whilst we do not run money entirely based on quantitative analysis we feel by removing some of the psychological barriers of share price and index level we can better determine whether or not there is true value in equities and how we should be positioned.