May 2013
What happens after the FTSE 100 reaches 7,000?
At the current rate of progress, 1,000 points in six months, it will only be a month or two before the FTSE 100 reaches 7,000. While some will ignore this figure the press will undoubtedly give it a lot of coverage. The figure itself is irrelevant because it has no value apart from measuring the capital of the 100 largest listed companies in the UK stock market by market capitalisation. The point that this level was also achieved 13 years ago is what will excite the media.
In fact the index in 1999 was a very different one from what we now see. Then it was dominated by technology companies and mining companies hardly counted at all. There is one other enormous difference between then and now, which many observers will overlook when they say equities have been a poor investment over that period because they are simply back to where they were.
Wrong
Over that time listed UK companies have paid out about three quarters of a trillion pounds in sterling as dividends. That money reinvested back in the stock market and compounded has generated a total return of over 50%. And that includes disasters like BP and the banking crisis.
Many will question whether the current valuation of the stock market is justified. No one can truthfully answer that question because no one knows what the future holds but we do know, as the FCA keeps telling us, that past performance is no guide to future returns.
Instead let’s look at what a share is. In essence it is simply a fraction of the ownership of a large company. As such it only has value if that company generates surplus cash which can be distributed to shareholders as dividends. As a piece of paper evidencing ownership of an enterprise it has no intrinsic value. Like gold it just sits there doing nothing.
However, as an entitlement to the surplus cash flow from a business it has a huge value. The oft quoted figure from the Barclays Equity Gilt Review tells is that £100 invested in the UK stock market in 1945 would now have a capital value of £8,011. Not bad. The staggering figure though is that the total return of that period, with dividends reinvested is £147,384.
Put that another way. If the prescient investor had given away the shares in 1945, but kept the right to the dividend stream he or she would still have £139,373. In other words the capital value is of little consequence and can almost be regarded as an option on a future income stream.
To help us answer the question of how to value the market today it helps to reframe it
Equity analysts, in aggregate, forecast that next year companies listed in the UK will pay out over £84 billion pounds in dividends. Based on current valuations that implies a prospective yield of 3.5%. There is no simple comparison but the easiest contrast is with the prospective yield on ten year UK gilts of 1.7%.
There is of course a huge difference between the two. One is an uncertain but real figure, i.e. inflation proofed. The other is more certain but is a nominal return that will be eroded by inflation. It is difficult to know which is best. However, it is certainly true that the cost of buying income in the UK has soared as annuity purchasers can tell you. The Bank of England bought of third of the gilt market and the FCA browbeat pension funds to buy bonds in order to be certain to match future liabilities in nominal terms. Consulting actuaries, the highest paid profession in the land, preferred to offer their clients a guaranteed poor return than the uncertainty of a better one by pushing pension funds in the highest allocation to bonds for decades. According to the Barclays Equity Gilt Review these long term funds hold 45% of their portfolios in bonds.
So if income from bonds is expensive is there any reason why income from equities should be much cheaper? If not then the price of buying an option on dividends from UK companies must rise. To get to the same price as bonds it implies equities should be worth twice as much. But what fool would forecast the FTSE at 14,000 after the last thirteen years?
Oh, hang on. Did someone say past performance is no guide to future returns? It is true of course that if the price of income falls, meaning bond yields rise, then the comparison would suffer. But where will the money from bonds go?
(The Munro UK Dividend Fund is a physical long-only smart-beta fund that invests in the FTSE 350 Index and complies with The Stewardship Code.)
How to invest Invest through Hargreaves Lansdown 