The FTSE 100 (‘Footsie’) is the UK’s main stock market index. Its members are the 100 largest companies listed on the London Stock Exchange’s main market, reshuffled quarterly. I’ve been following this blue-chip index since its 1984 launch, when I was a mere youth. Over 37 years, I’ve seen the index soar and slump, surge and crash, again and again. But now I feel that this UK index — and the underlying shares it represents — may be too cheap. Here’s why.
The FTSE 100 lags the S&P 500
Over the past five years, the FTSE 100 is up by 8.2% to stand at 7,130.47 as I write. In contrast, the US S&P 500 index has more than doubled since mid-2016, rising 103.3% to 4,330.09 points today. That’s a massive outperformance by US stocks. Indeed, it’s one of the largest in my long life of market-watching. Similar gaps emerge over shorter timescales. Over one year, the S&P 500 is ahead by 39.3%, while the FTSE 100 has gained 14.3%. Likewise, the S&P 500 has gained 15.3% in 2021, while the Footsie lags behind yet again with a 10.4% uplift.
One possible reason for the supremacy of the S&P 500 over the FTSE 100 could be a ‘Brexit discount’. This theory suggests that, because of trading and political difficulties following the UK’s departure from the European Union, UK stocks deserve lower ratings. After all, our government has struggled with new border controls, trade deals, and so on. But I’m not terribly convinced by this argument, largely because around three-quarters (75%) of FTSE 100 earnings are generated overseas.
My view is based on the simple observation that ‘money moves markets’. Investors seem more than willing to keep driving up the stock prices of go-go US growth stocks. This momentum-following has been very pronounced since the lows of March 2020. Conversely, the old-economy, value-orientated FTSE 100 is still seen as the poor cousin of its American counterpart. But this leaves the Footsie on a huge valuation differential to the S&P 500. This suggests that either UK shares are too cheap or US stocks are too expensive. I think it might be a bit of both, to be honest.
The Footsie offers better value (or does it?)
As a veteran value investor, I aim to make money from capital gains (selling shares for profit) and dividends (regular cash distributions from companies). Thus, if the FTSE 100 appears cheap and offers superior dividends to the S&P 500, then I’m better off buying the former, right? Maybe not.
Right now, the S&P 500 trades on a forward price-to-earnings ratio (P/E) of 22.5 and an earnings yield (EY) of 4.4%. And the S&P 500’s current dividend yield is 1.35%, according to the Wall Street Journal. On the other hand, the FTSE 100 trades on a forward P/E of 14.6 and EY of 6.9%, plus it offers a forecast dividend yield of 3.7%. For me, as a value-seeker and income investor, there’s no question that the Footsie looks historically cheap compared to its US equivalent.
But speaking of history, there’s one big flaw with my thinking.
Historically, the US economy and company earnings have grown at much faster rates than here in the UK. Therefore, it might be worth paying more for faster-growing US company earnings, agreed? This argument also rings true for me. That’s why I continue to invest my family portfolio into both cheap UK shares and pricier US stocks. Hopefully, this cross-Atlantic diversification delivers the best of both worlds!