Fear can certainly send the markets to cheap levels. Today, I want to show you two reasons why I think we’re almost there with the FTSE.
Problem is, cheap can still get cheaper. I don’t know if we’ve hit bottom yet. So I’m not committing my cash reserves for the moment.
But I’m warming up to the idea. Because I think we could be approaching one of the best buying opportunities in years.
Here’s why.
The market is trading at less than ten times earnings
As you can see from the two-year chart of the FTSE, the index has back-tracked to last summer’s levels.
FTSE 100 – two year chart
Oh well, no big deal you may think. We’ve retraced about half our gains since the market bottom in 2009.
But be careful. This chart is deceptive. It’s not measuring the right thing.
To measure the real value of the FTSE, a nominal figure isn’t that useful. For a more meaningful valuation we need to look at some fundamentals. Let’s start with the price/earnings (PE) figure.
In all the fun and razzamatazz of the last week, it was easy to miss that the PE on the FTSE went to under ten times earnings. In fact at around 5,000, the PE is just over eight times earnings.
Now my rule of thumb is: if it’s under ten, it’s worth looking at again. So let’s dig a little deeper.
On 1 June last year, the market closed at 5,163. That’s roughly the same as today. And on that figure the market traded on 13 times earnings.
That’s incredible. Though the FTSE has barely changed, it’s now on eight times earnings compared to 13 times last summer. That means the market would have to go up around 50% to be trading at the same valuation based on price to earnings!
So FTSE companies are clearly reporting great earnings figures. With so much of their earnings coming from overseas, the low pound is helping boost profits.
I’m not saying corporate profits will stay at these levels. Let’s not forget, last year’s earnings (which mostly relate to 2008/9) were a little strained. So it’s perhaps not surprising that corporate profits have bounced back. And if we dip back into recession, there will be casualties.
But the FTSE has a very good track record of growing earnings over the long run. Taking the long view, there does seem to be value here.
And there’s more.
The discount rate has changed
As well as PE measures, you can value a market by discounting future cash-flows to present value. What do I mean by that?
Well, the discount rate is used to calculate how much the expected future income from an investment is worth right now (the net present value). Discounting is basically the trade-off of having a certain amount of money now and a promise of another amount in the future. The higher the risk, the higher the discount rate.
What does this mean when you apply it to the market? Well the rock bottom interest rates we have today imply a high net present value for stocks today. In other words – stocks look cheap!
In fact that’s part of the reason why Bernanke has promised on rock bottom rates for two years – to breathe life into stocks. Mervyn King, though a little more circumspect, has hinted at much the same.
Of course, this isn’t news to us here at The Right Side. I’ve consistently said that rates will stay lower for longer than anyone expects. Well, now the big guns have come out and said it too.
Is now the time to invest?
At 5,000, the FTSE yields close to 4%. And with profits rolling in nicely, those dividends are more than three times covered.
In the depths of the credit crunch, the market bottomed out at 3,500 – and that was seven times earnings. So on a PE basis, we’re not far off that bottom now. What’s more, with rates pegged down for the foreseeable future, stocks don’t look bad value.
Does all of that embolden me?
Nope. I’m sitting tight for now. There’s not enough blood on the streets to spur any big purchases from me.
But if you’re considering picking up stocks for the long run, you may find today’s prices compelling. So I’m going to be keeping my eye on a few potential investments.
• This article is taken from the free investment email The Right side. Sign up to The Right Side here.
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