That’s more than 10 times the same period in 2008. Investors have been piling back into the markets.
I’ve noticed the same thing among a growing number of acquaintances. People have been approaching me for stock tips, or advice on investment funds.
“Why do you want to put your money in the markets?” I ask.
The response is usually “Because the markets are cheap aren’t they”
Well, let’s take a careful look and see why so many investors think the markets are cheap. And I’ll explain some serious flaws in their thinking, so you won’t make the same mistakes
The problem with seeing patterns
We humans have an insatiable appetite for patterns. We yearn for patterns and see them in charts even when they don’t exist. Take the FTSE 100 chart over the last 15 years. 15 years seems to be a long enough period for the average person to recall. (Just a reminder: back in 1996 a young Tony Blair was just beginning to take control of the Labour party).
FTSE 100 From 1996 Until Present
You’ll notice the two enormous peaks immediately. And they do look like they are part of a cycle don’t they? We can’t help thinking that – the brain is hard-wired to see the pattern. Look at where we are today (far right of the chart). We must be on the way back up to the next peak – mustn’t we?
Our propensity for seeing patterns and repetitions means that we expect the FTSE to muddle its way back to the 6,500 area. Not only that, but we’ll probably tell ourselves to expect some more growth on top of this ….. Stock markets always go up over the long run you know!
The chart rams the point home. The chart hits low points (‘testing lows’) and then recovers. Events like the 1998 Asian financial crisis, dotcom bust, September 11 th terrorist attacks, or banking crisis last year all tested the markets resilience – every time the market bounces back. This reinforces our belief in the pattern.
So, put simply, we look at the chart and identify the pattern. We see where we are now - way below the 6,500 peaks. And we just can’t help believing that the market is cheap.
But this is crazy….
History is no guide to the future
If you’re a sensible investor, you can’t simply value investments relative to historic prices. Would you say that Lloyds is cheap at 50p today just because it used to trade at £5.00? (I hope the answer is No!).
Sensible investing means valuing investments consistently. And the most common ratio that does this is the Price Earnings (PE) ratio. The beauty of PE is that you can use it for an individual company, or you can take the average to assess the market as a whole.
Generally speaking, a PE of less than 10 is considered cheap. The market’s long-term average is 14. When the market hit its low in March last year, the market was trading at 7x. Bargain hunters took to the market – while private investors were having a nervous breakdown.
So what is the PE for the market as a whole right now?
Here’s the crucial number. Today the FTSE is trading at about 5,350. And it has an average PE of 16x.
The last time the FTSE was at 5,350 was sixteen months ago, in September 2008. At that time it had an average PE of 11x.
So there are two vital points to note:
- Even though FTSE is at the same level - 5,350 - as it was in September 2008, the market is way more expensive today than it was back then. Why? Because earnings are much, much lower. In fact, with a PE of 16 now, compared with a PE of 11 in 2008, it’s nearly 50% more expensive!
- Even though the market was cheaper back in 2008 than it is now, nonetheless it subsequently fell all the way down to its lows of 3500. A drop of 33%!
The16x multiple that we trade at today, may be considered about fair in a normal market. It’s pretty close to its long-run average.
But that’s ignoring one crucial point. This is not a normal market! There are all sorts of risk factors out there to take account of. The financial environment is in a state of confusion – and so are investors.
What if the markets head south again?
If the markets wobble again – perhaps as a result of sovereign debt issues, or perhaps something totally unexpected – and head back to 7x earnings (what I would call cheap), that would mean the FTSE would go to the 2,400 level!
So the point is this: the market is not cheap. At a push, you could say it’s fair value.
If the market does become cheap, it could easily fall to 2,400.
And if you think you can get better returns outside the large caps think again. The FTSE 250 (smaller companies than the FTSE 100) is trading on an awesome 26x earnings.
What should you do now?
Although the FTSE is trading at 16x and appears fully valued, it’s important to remember that there are some great disparities within the index.
For instance in the FTSE Industrial sector, Aerospace and Defence trades on a miserly 9x, while Electronic & Electrical Equipment trades at a lofty 27x.
Or consider the Telecoms sector where Mobile Operators trade at a reasonable 8x compared to Fixed Line Operators trading at an incredible 61x earnings.
It’s time to cash in some profits from the companies and sectors that have shot away from reality. Hold on to some cash - the best advice in these markets is to keep some ‘powder dry’– you never know, you may be given the opportunity to pick up stock on the cheap.
Good investing,
Bengt Saelensminde
For The Right Side
P.S. Before you leave, make sure you’ve seen this. This is your best shot at withstanding the shocks in store for UK investors:
THE "GREAT FINANCIAL DECEPTION" OF 2010
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