Last week witnessed a new high for the FTSE 100 index after market friendly remarks regarding US monetary policy from US Federal Reserve chairwoman, Janet Yellen. The new closing high of 6949.6 was reached on Tuesday 2 January 2015, surpassing the previous record close of 6930.2 on 30 December 1999. How comparable are these peaks and should investors worry at the thought of equities reaching new highs?
Back in 1999 the stock market was driven by the dotcom bubble, which ultimately burst. At the peak, investors were guilty of hysteria and were willing to pay an average of 25 times the earnings of a company to own shares compared to a more reasonable 16 times earnings today.
The dotcom bubble also changed the components of the index. At the previous peak, the FTSE 100 had 14 technology companies in its constituents. Now just four remain. Mergers and acquisitions have also caused names like British Steel, Cadbury and Boots to fall out of the index.
Income driven investors will also remind you that the FTSE 100 index is purely calculated according to the capital value of share prices. This method ignores the fact that a large part of an investor’s return comes from receiving and reinvesting dividends. Indeed, since 1900, an index with income reinvested would have grown 170 times more than the same shares without reinvestment.
In conclusion, a sensible approach is to focus on total return and whether prices are reasonable relative to earnings rather than whether prices are high relative to the past.