FTSE 100 To Reach 12600 By 2032?

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• GOOD NEWS. After 22 years of going nowhere, the FTSE 100 is finally below fair value.

The FTSE isn’t much above where it was in 1999, but finally, after 22 years of going nowhere the FTSE 100 is now looking attractive once again.

As we all know, past performance is no guarantee of future performance, and that applies to bad performance as well as good.

So instead of extrapolating the FTSE 100's poor track record into the future, we need to ask ourselves, what is going on here? Why has the FTSE 100 performed so badly?

If we do that, then the FTSE 100's future begins to look a little less bleak.

Why was it so high 22 years ago?

Everyone knows the story of the dot-com bubble, where the valuations of internet-related stocks went to the moon and then crashed back down to earth.

We can accurately capture that story by looking at the FTSE 100's CAPE ratio, or cyclically adjusted PE. CAPE is an improved version of the standard PE ratio because it compares the FTSE 100's price to its inflation-adjusted ten-year average earnings, and that smooths out the short-term earnings volatility that can make the standard PE ratio somewhat unreliable.

Fundamentally, CAPE works just like the standard PE ratio: when CAPE is above average the price is high and when CAPE is below average, the price is low.

The following chart plots the FTSE 100's price (in black) superimposed over a CAPE rainbow, where red shows where the FTSE 100 would have been at high valuations, yellow shows where it would have been at average or "fair" values and green shows where the index would have been at low valuations.

From looking at the chart, we can see that in 1999, the price was simply wrong and anyone looking at earnings could have told you that.

Predictably, it crashed and we can see the fall in the rainbow as it moves from red, through yellow to green. It is nearly always the case in a crash that the sell off goes too far. We see it again here in 2003 when it reaches the bottom and looks ‘cheap’. This happens again in 2009, and 2020.

Those were all exceptional circumstances. What we are in now, is more of a price adjustment due to a renormalisation of interest rates and surging inflation (which history tells us will always be temporary).

Therefore, below value, is good enough to make a long term prediction.

While the index's price has gone nowhere, the amount of capital employed by the 100 companies that make up the index and the earnings and dividends they generate, have more than doubled.

So while the price remains frustratingly close to 7,000, the increase in earnings has reduced the FTSE 100's CAPE ratio to 15.

That's below the long-term average of 16, so the FTSE 100 is currently priced below fair value.

If you're not familiar with the idea of fair value, in this context it's just the price needed to make CAPE equal its long-term average of 16.

As of today, fair value is 7,700 compared to a current price of 7,200.

500 index points isn't a huge margin of safety, but it does give you a slightly above average dividend yield of 3.7% and it's a lot bigger than the margin of safety you'll get from the still overvalued S&P 500.

Long term predictions are easier than short term ones. This is why we don’t like to look at portfolios under a monthly microscope.

Nobody knows what will happen tomorrow, but if you have money to invest for the long term, look ahead.

The FTSE 100 is likely to be significantly higher ten years from now.

Coming up with a central scenario for ten-year total returns is actually quite easy.

All you have to do is estimate the growth of earnings and dividends over the next ten years and estimate what CAPE will be at the end of that period.

Taking each in turn, my central scenario assumes that:

• Earnings and dividends grow at 5% per year to 2032

This assumption is based on the fact that over the past 35 years, the FTSE 100's cyclically adjusted earnings (the ten-year inflation-adjusted average) have grown by 5% per year on average.

Those 35 years cover periods of higher and lower inflation as well as booms and busts, so I'm comfortable sticking with 5% as my estimate for future earnings growth.

Also, the FTSE 100's dividends have grown by 4.5% over the last 35 years. Over the long-term I would expect earnings to grow in line with dividends, so I'm going to assume that dividends will also grow at 5% per year, which is only fractionally higher than the 35-year average.

• The FTSE 100's CAPE ratio is 16 in 2032

Since we have no idea what CAPE will be ten years from now, I'm going to assume that CAPE is equal to its long-term average. This could be wrong, but the long-term average is still the best guess because it's the closest value to all the other possible values.

With those assumptions in place, we can use them to calculate some outcomes:

• The FTSE 100's price reaches 12,600 by 2032

This is simple arithmetic. If cyclically adjusted earnings grow at 5% per year to 2032 (from 483 index points to 787), then a CAPE ratio of 16 would leave the FTSE 100 at 12,600.

A scenario where the FTSE 100 reaches 12,600 by 2032 is both conservative and realistic. Many will think of it as optimistic but that is because people simply cannot imagine the FTSE 100 at 12,600.

We have all become so used to seeing it at 7,000 (for the millennials, perhaps for most of their lives). This is a psychological trait known as the recency bias, and it's one you should be aware of because it makes people think recent trends (like bull markets in the US or low valuations in the UK) will go on forever. Which of course they almost never do.

Let's move on to total expected returns to 2032, which depend on the starting price. Today's price is 7,200, so here are the expected returns from our central scenario:

With a starting value of 7,200:

• The FTSE 100 will produce a return from dividends of 48% by 2032
• The FTSE 100 will produce capital gains of 75% when it reaches 12,600
• The FTSE 100 will produce total returns of 123% by 2032, or 9.5% annualised (including but without reinvesting dividends)

For those who are worried about investing with a recession on the horizon:

Recessions are a necessary part of the economic cycle, as we found out when excessive efforts (by central banks and governments) to avoid recessions in the early 2000s led to a credit bubble and a global financial crisis in the late 2000s. And a decade of near-zero interest rates used to avoid weak economic growth have now caused all manner of asset bubbles and capital misallocations.

So while earnings and dividends may fall for a year or two, history suggests that average earnings are very likely to march upwards over the next decade, as they almost always have in the past.

On that basis, our scenario for 2032 is realistic and we would be happy to invest in FTSE 100 index at its current valuation.

If the FTSE 100 does behave as expected over the next 5 or 10 years, then one of the best things you could do, would be to link to one of The Portfolio Platforms leveraged trackers.

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