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Here’s why the FTSE 100 could soon crash through the 8,000 barrier

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It’s only about a week ago that the headlines were screaming statements like “FTSE 100 reaches new record high,” and the UK’s top stock market index has soared by 36% since its low point in February 2016.

At a little over 7,700 points now, are things getting overheated and should we be taking some profits? I say no, and I think we’re still looking at an undervalued stock market. Before I tell you why, let’s dispense with the tabloid headlines. 

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The thing with the FTSE 100 is that, over the long term, it goes up… and up and up. And if we averaged out the short-term blips and drew a smooth line through the chart, we’d see a new record high every single day.

Some of the FTSE’s rise will be down to the value of Sterling, as the index is populated by international companies.

The dollar effect is probably not as hard as might be feared — though the pound crashed to around $1.20 at its lowest point after the Brexit referendum, it’s back to $1.38 for a mere 5% drop. But we’re still looking at a 17% fall against the euro, and that will surely have a boosting effect on the FTSE.

A weak decade

Looking back further, the FTSE has gained only a modest 32% over the past 10 years, which is a pretty weak return. So could the recent gains simply be a recovery from a long spell of undervaluation? I think so, especially as other stock markets have seriously outstripped it.

In the USA, the Dow Jones Industrial Average has stormed through the 25,000 level in January. And when we examine the history here, we see the Dow has doubled over the same decade — that’s three times the performance of the FTSE 100.

And what can we say about the NASDAQ 100? Other than that it’s soared by more than 250% over the same 10-year period. In Germany, the DAX is up over 90% in the same timescale, and the Japanese Nikkei 225 isn’t too far behind with a gain of nearly 80%.

Compared to these top international indices, our own dear FTSE 100 is looking pretty pathetic — and not at all overvalued, especially considering that its biggest constituents are very much global giants.

Dividend yields

If that’s not enough to convince you the FTSE 100 is still undervalued, let’s turn to dividend yields. Over the past 10 years, the FTSE 100 has provided average total dividend yields of about 3.4%. That’s not bad when considered as a bonus on top of its capital appreciation, and dividend investors typically do a lot better than that by choosing only the higher yielders.

Now, according to the latest Dividend Dashboard from AJ Bell, which gives us an analysis of the FTSE 100’s dividend outlook every quarter, in 2018 our biggest index is set to deliver a cracking 4.3% dividend yield. The analysis does point out that there’s some weighting by poorly-covered dividends from Royal Dutch Shell and BP, but I don’t see a long-term threat there now that the price of oil is recovering nicely.

Assuming those dividends hold up, for the FTSE to return to its decade-long average, it would have to carry on rising to 9,800 points. That surely suggests undervaluation.

I reckon we’ll be looking at a break through 8,000 points sooner rather than later, and the elusive 10,000 level might not be too far away.

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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has recommended BP and Royal Dutch Shell. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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