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Value begins at home

Unlike in the US, large-cap valuations in the UK point to decent returns in the coming years

The US stock market is plainly dear right now. This points to poor returns over the coming few years on the world's most important stock-market index. Indeed, according to James Montier of GMO, it is quite possible that the S&P 500 will deliver a real total return of zero - or even less - over the next seven years.

Like Wall Street, the UK has just enjoyed a five-year bull market. So what do valuations here say about the outlook for large-cap shares, both in the near future and further out? To answer this, I've looked at several famous and not-so-famous metrics to see what sort of returns history suggests we might expect from the FTSE 100 and FTSE All-Share indices in the years ahead.

Healthy yield

We all know how critical dividend income is to our long-run returns. But the dividend yield can also help predict price moves over the coming years. A high yield on an index often gives way to high capital returns. Lately, the dividend yield on the FTSE 100 has been about 3.67 per cent, almost exactly in line with the average yield since 1985.

This one metric alone has explained around one-quarter of subsequent returns over a two-year horizon. Past experience suggests the possibility of an annualised real total return 11.5 per cent over the next couple of years, and 4.6 per cent annualised over a seven-year timeframe.

Bravo, Maestro!

A rather more sophisticated forecast comes from the ShareMaestro model. This computerised valuation tool weighs up likely dividend growth, inflation, bond yields and riskiness. As of 14 March, it worked out the FTSE 100's intrinsic valuation as 8120, some 24 per cent greater than its recent price. This may be conservative, as it assumes that dividends will stay frozen in real terms over five years. Based on past experience, this valuation could give way to a return over two years of 8.2 per cent.

Low-flying CAPE

Rather than working out a price-to-earnings ratio based on a single year's earnings, a "cyclically-adjusted" ratio that uses several years' data can give much more telling insights. The UK total market is trading around 9.8 times the past decade's earnings, compared to its long-run average of 11.5. This hints at a possible 11.5 per cent annualised real return over the next two years, and 8.5 per cent on a seven-year view.

View from the peak

Critics of CAPE typically complain that it is misleading to focus on past bad earnings. The price-to-peak earnings or 'Hussman' PE addresses this by comparing today's price with the maximum earnings achieved in the last cycle. This is therefore a bullish tool which assumes that if an index's earnings are below their all-time peak, they will recover their former glory. On 11.6 times peak earnings, the FTSE could deliver an annualised return over seven years of 10.1 per cent.

Buffett's take

In the late 1990s, Warren Buffett warned that Wall Street was dangerously overvalued based on the total capitalisation of US stocks with the size of the US economy. For the UK, this ratio currently stands at around 138 per cent, which is the level it reached just as the market peaked in 2007. The long-run average is just 75 per cent.

On the face of it, this may sound worrying. On a two-year view, today's ratio might imply negative annualised returns of 3.78 per cent, and minus 0.18 per cent on a seven-year view. At least for the UK, though, this indicator has historically had low predictive power. This is not altogether surprising given the flawed assumptions behind it.

Good value in my book

Comparing a market to the value of the assets of the firms that make it up can give a rather different perspective to relying on earnings and dividends. The price/book value for UK equities has been one of the most effective predictors of subsequent returns, particularly over longer periods of up to a decade. The UK market has lately been trading on around 1.8 times book value, almost exactly in line with the average since 1980.

British big-cap is good value

The UK stock market overall offers decent value, which points to mid single digit real total returns over the coming years. This value is concentrated in the large-caps of the FTSE 100, particularly in natural resources. Given the valuation gap between US and UK equities, there is a clear case for switching holdings away from the former and towards the latter.