At above 7,000, just how expensive is the FTSE 100 today?

The FTSE 100 burst through 7,000 last Friday to notch up a record close. But don’t read too much into it – it’s certainly not a signal to pile in.

While chancellor George Osborne might have appreciated the timing – so close to his final budget (of this government at least) – really the FTSE 100’s record close of 7,022.51 owed much more to the US Federal Reserve.

The US central bank last week hinted – via a surprisingly cautious take on the US economy – that a rate hike in the US is still some way off. Investors had been fretting about the impact of rising rates – but they’re now clearly assuming a stay of execution until at least the second half of the year now.

We also had some rather dovish messages coming out of our own Bank of England last week. Chief economist Andy Haldane suggested that UK interest rates might need to be cut to zero to tackle deflation.

The upshot is that recent, mounting concerns over the removal of liquidity on global markets have eased. As Jason Hollands, managing director of investment group Bestinvest put it: “With the Fed easing down expectations of a near term rate hike, the good times of easy money are set to roll-on for a little longer.”

The FTSE 100’s rise above 7,000 comes 17 years after the index hit 6,000. It had come close to putting on that 1,000 several times before – most notably in December 1999 at the height of the dotcom boom.

But record level or no, the level of the FTSE 100 in itself is no measure of whether or not UK-listed shares are cheap or expensive.

So what is the true value of the FTSE 100?

There are many ways to try and assess how cheap or expensive a stockmarket is. One common measure is the price/earnings (p/e) ratio. This measures a share’s price relative to the annual profit earned per share – for a market, it’s the same thing, only covering all the constituents. In 1999, says Bestinvest, the FTSE 100 was on an average p/e of 27 (very high by historical standards), partly due to the very high valuations of technology and telecom companies. Now it is just below 16.

“Current UK valuations are a little higher than the long-term average, but they aren’t astronomical either and certainly below those of US equities where the S&P 500 index is on 20 times earnings,” says Hollands.

You also need to factor in inflation when comparing the index over long periods, says Hollands. Bestinvest reckons that once you adjust for inflation, as measured by the UK Consumer Price Index, the FTSE 100 index would need to be at around roughly 9,500 points to be comparable with its (arguably overvalued) 1999 peak of 6,930 points. That’s a long way off where we are now.

That said, we’re hardly at bargain levels, and the overall environment looks tricky. As Tom Elliott, investment strategist at adviser deVere puts it, the rally following the Fed’s mild change of heart “does highlight how dependent global stock markets have become on the current Fed funds rate of almost zero.”

Elliot adds: “We must remember that underlying the six-year rally in risk assets, which began in March 2009, is massive central bank intervention in the form of ultra-low global interest rates and quantitative easing. This has disabled the financial markets’ ability to signal changes in the real economy, leading us to be very cautious over buying into any rally.”

In short, better to stick with genuinely cheap markets – we’ve looked at some in the current issue of MoneyWeek magazine. If you’re not already a subscriber, you can get your first four issues free here.

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