Market Noise

Twin Peaks

On Tuesday the FTSE 100 index reached price levels last seen at the top of the tech bubble.

Figure 1: FTSE 100 reaches tech bubble level

This has grabbed some attention in an investment media always hungry for content, and it is the type of headline that appeals. It is factually correct (which always helps) but it is also loaded with connotations that appeal to human emotion. Because we are hardwired to think of the world in terms of stories it is very hard to see that headline, or look at the chart above, and not have a knee-jerk sense of disquiet.

Nagging voices take hold: “Look what happened last time stocks reach these levels!” “What if I have to 15 years to make my money back…?” “Is it time to cash out?”

For most of us this initial gut-reaction is short lived. We engage what behavioural psychologists call ‘system 2’ (more rational, but more effortful thought process) and realise that the index price on its own is just a number.

Firstly, it doesn’t tell us about total returns. If one had invested at the top of the tech bubble but reinvested all dividends since then it still would have been painful (it would have taken six years, rather than fifteen to make back your money) but your return to would look far healthier. And, as we have mentioned elswhere, you would still have beaten cash.

Figure 2: You’ve made 67% since the top of the bubble

Even more important than this though is the age old adage (and regulators’ favourite): ‘past performance is no guide to the future.’ Though some technical analysts may disagree with me, the level of the index today tells you very little about where it is going in the future.

What does seem to be a guide however, at least over the long term, is the valuation of an asset: what share of future earnings am I getting for my money? Here we can see that the picture in the UK is very different to that at the turn of the millennium.

Figure 3: What are you getting for your money?

It was buying expensive, rather than buying high, which led to the painful experience after the tech bubble, and this is reflected across many developed equity markets. Figure 4 shows the valuation of various indices at their respective index high points and figure 5 shows the subsequent returns.

Figure 4: Valuation signals at peak index levels


Figure 5: Performance after the peak

So it was Italy, Germany and France that were the most expensive at their tech bubble peaks and it is those indices that performed worst over the following 14 years or so. The Eurozone crisis will of course play a role in the outperformance of the US and UK, but the disparity of return between Italy and Spain is notable.

P/E ratios are a blunt tool at best for making cross market comparisons but for what it’s worth, and that is certainly more than headlines about index levels reaching all-time highs, here is how they look today:

Figure 6: Value signals at peak levels, versus today

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.