The news that the FTSE 100 Index of blue chip shares has reached a record high this week has caught the attention of the press. After all, the last time the ‘Footsie’ scaled within reach of 7,000 points was in 1999 during the heady days of the ‘dot-com’ bubble.
However, it is important to understand that the level of the FTSE 100 Index is not a particularly useful way of measuring whether equities are cheap or expensive. The Index represents the combined market capitalisation (size) of its constituents and therefore an increase in the Index can reflect companies having genuinely grown over time, as well as new major international firms having joined the Index. It does not necessarily mean that company valuations have become more expensive.
When drawing comparisons between the UK stock market now and in 1999 it is vital to factor in the impact of inflation over the last 15 years. We estimate that once adjusted for inflation, as measured by UK Consumer Price Index, the FTSE 100 Index would currently need to be at around 9,472 points to be comparable with its previous high in 1999 of 6,930 points. That’s some 37% higher than where it is now.
Valuations on UK equities are a very long way off 1999 levels
It is also important to note that the make-up of the FTSE 100 Index is very different today from what it looked like in 1999 when telecom and technology companies represented 18% and 3.8% of the FTSE 100 Index respectively. Today these sectors represent just 5.1% and 1.1% of the FTSE 100. The broader UK market back then had seen a frenzy of Initial Public Offerings of new ‘dot-com’ internet companies. These companies traded at valuations that reflected the belief in their future potential rather than actual earnings. And of course in many cases, those earnings never came through.
There are numerous ways to try and assess the value of shares, but the most common one is a measure called the Price/Earnings (P/E) ratio. This measures a share's price relative to the annual profit earned per share. In 1999, the FTSE 100 was on a P/E of 27 times earnings, in large part due to very high ratings of technology and telecom companies, whereas now it is hovering at around 16 times earnings. Current valuations are a little higher than the long term average but they are a very long-way off those seen in 1999. In an international context, it is the US market that looks the most expensive of the major stockmarkets with a current P/E of almost 20 times earnings.
Ideas for investors nervous about market levels
Unless you have a crystal ball to predict the future, it is impossible to accurately foresee whether markets will keep rising or could be ready for a set-back in the short term. For example, the US equity market has looked expensive for some time on a number of measures, but over the last year the S&P 500 Index has soared almost 25% higher in total return terms.
One way of addressing concerns over when to invest is to do so on a regular basis, either through a monthly savings scheme or by drip feeding cash into the markets in periodic lump sums. Monthly investing helps smooth out some of the ups and downs so that over a year you will broadly invest at the average market level. It’s a great discipline to keep on saving through the tough times and the good times.
There is no need to forgo your £15,000 ISA allowance this tax year if you are unsure of whether the timing is right: the good news is you can always open your ISA with cash before the end of the tax year and decide when are where to invest it later. After all, your ISA allowance is precious and if you don’t use it, you will lose it.