Fool's Eye View

[ December 13, 1999 ]

Will the All-Share Rise 9% Next Year?

By Rob Davies (TMFEssex)

This is the time of the year when we look back over the last 12 months and recall our investing triumphs. We might also look back at some of our less successful forays into the investing world. Those historic aspects will be covered in more detail in other articles in the Fool as we approach Christmas.

But for today I thought it would be interesting to take an objective look at next year and see what it might bring. The only element of history I am going to bring into this is the number 2,695. That was the level of the FTSE All-Share Index at the start of 1999. Throughout this article I will refer only to the All-Share index because it is more representative of the market, although I do appreciate that the vast bulk of its value lies in the top 100 shares.

From Friday's FTSE All-Share closing level of 3,153 that index level of 2,695 seems an awfully long way away. In fact it is 17% lower and it seems that, barring catastrophes in the next two weeks, that is somewhere close to the performance we shall record for the year.

On top of that 17% we should add another 2.4% for dividend income for the year. So all told, in round numbers, the UK equity market has given us a total return of about 20%. That looks pretty good compared with the 5% or so we would have got from putting it in the bank and the negative return of 5.6% the gilt market provided over the last twelve months.

Over the long run that sort of return from the equity market cannot be sustained year after year. When the economy is only growing at 2% or so it is patently not feasible for the collective valuation of industry to grow 10 times as much, year in and year out. What has made this year so surprising is that this strong equity performance has come in a year when gilts have fallen and interest rates have gone up. Normally, gilts and equities move pretty much in the same direction, although usually by different amounts.

So if 1999 was a bit of an anomaly, what does 2000 hold in store for us?

According to economic theory the returns from equities should match what we get from risk-free investments and give us a bit more to compensate us for taking the risk.

Given that (supposedly risk-free) gilts lost money this year I suppose a good result would have been for equities to break even in 1999. Nevertheless, let us take the starting point as the 5.5% we can get pretty much risk-free from lending money to a nice safe bank. So from Friday's FTSE All-Share close of 3,153 we ought to simply add 5.5% to that to get the projected level of the FTSE All-Share Index at the end of 2000. However, don't forget the 2.4% dividend yield we ought to be able to receive. In that case we should count on a capital gain of 3%. That indicates a closing level of 3,247 for 2000. Quite simply, if we don't get that level then our money is much better off sitting in the bowels of Fat Greedy Pig Bank (LSE: OINK) and being on-lent to persons of dubious creditworthiness, like everyone else.

But it isn't as simple as that because we also have to factor in the risk premium for equities. Exactly how much that is keeps hundreds of economists harmlessly employed for hours on end. In fact if all the economists involved in this study were laid end to end they still wouldn't reach a conclusion. For years it was assumed that the figure was 6%. That figure was simply derived by the averaged annual outperformance of equities over gilts. However, there is now a sizeable body of opinion that says the equity risk premium has shrunk to zero.

As with so many things in life, the right answer will never be known. However, for the purposes of this exercise we will assume it is 6%. So, to calculate the expected level of the All-Share Index in one year's time we take the base rate of 5.5%, subtract the dividend yield of 2.4% and add the equity risk premium of 6% to give a figure of 9% (in round numbers).

On that basis a target figure of 3,437 looks attainable over the twelvemonth.

There is of course a caveat to this, because the logic is slightly illogical. If, as is widely expected, the Bank of England raises interest rates next year it implies that our target must be raised too. Another 1 percentage point on interest rates should be reflected in another 1% return for the All-Share, or another 32 points. Hey, this is a great game. We can get higher and higher returns from the stock market by raising interest rates to ever-higher levels. Just like this year.

But we know in our bones that this cannot make sense. At some point consumers say something like, "Ouch, these interest rates are hurting. I'm not going to spend any more money for a little while". When that happens retailers start to suffer, and then suppliers, and so on and so on.

But in fact that has already happened this year. Retailers have had a terrible time, but that hasn't stopped the market going up. Which rather suggests we could be living on borrowed time already.

But who cares? As Warren Buffet says, he buys companies, not markets.

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