What could the next 10 years hold for the UK stock market?

In this article we’ve looked at historical value indicators and data points that we’ve found interesting. However, readers should take it with a pinch of salt. This is purely hypothetical and the reality will inevitably differ somewhat from what we discuss here.

We always say investors should take a long-term view – at least five years and ideally longer. That gives you the best chance of achieving a positive return.

Take the FTSE All Share index. Since launch in December 1985, there have been just 71 days where investors would end up holding less than their initial investment ten years after investing, on a total return basis. All of those were in 1999 (when global stock markets were in the midst of the most spectacular bubble of the modern era). Even then there are only ten days when losses were higher than 10%, and none exceeded 15%.

While historically the chances of a negative return over a 10 year period might be small, the range of positive results is very wide. And over shorter periods the volatility is even more pronounced, as you can see from the table below.

Source: Lipper IM, to 30/04/2021.

Of course, as regular readers will know only too well, past performance is no guide to future returns.

All investments rise and fall in value, so you could get back less than you invest.

What could the future hold?

Given the range of possible returns, what could happen if you invest in the UK stock market today? Well, there’s no way to be certain, but we can look at how the market has gone on to perform when it’s been trading at this level in the past.

Because no single indicator is infallible, we’ve looked at a range of different valuation metrics. Even putting all these metrics together is no guarantee – although it should give you an idea of the kind of returns you could potentially see.

1) Stock market dividend yield

One of the benefits of investing in a company’s shares is that you’re entitled to any dividends the company chooses to pay. A dividend yield measures the percentage of your current investment that you have received as a dividend in the past year.

All things being equal, when stock prices are high, dividend yields are low, and when prices are low, dividend yields are high. Unsurprisingly then, a high dividend yield has historically been associated with better stock market returns.

Chart showing FTSE All Share dividend yield and subsequent 10 year total return

Scroll across to see the full chart.

Past performance is not a guide to future returns. Source: Refinitiv, 24/05/21.

The FTSE All Share currently trades on a historical dividend yield of 2.77%, a level which has historically been associated with a 71.7% total return over the next ten years –averaging 5.6% a year.

That might sound healthy but is actually below the long-run average for the index. It’s also worth bearing in mind that because of the pandemic, lots of companies that might ordinarily have paid a dividend chose not to last year. That means the dividend yield might be artificially low at the moment – so it’s worth sanity checking the result against other valuation metrics. And as always, yields are variable and not a reliable indicator of future income.

2) Stock market price/earnings ratio

A price to earnings (PE) ratio is perhaps the most common measure of stock valuation. It looks at the amount investors are willing to pay for one pound of profits – for example a PE ratio of 11 means that investors are willing to pay £11 for every £1 of profit.

The FTSE All Share currently trades on a PE ratio of 21.96. That’s some way above the average PE ratio of 17.66 recorded since February 1993 (the earliest date for which data is available).

Chart showing FTSE All Share PE Ratio

Scroll across to see the full chart.

Past performance is not a guide to future returns. Source: Refinitiv, 24/05/21.

Like dividend yields, there’s historically a relationship between PE ratios and stock market returns. When PE ratios are low, future stock market returns have tended to be high. When the market has traded at a similar PE ratio in the past, it’s gone on to return 65.5% over ten years, equal to an average annual return of 5.2%.

However, today’s PE ratio could be artificially low. Historical PE ratios include profits from last year, when companies were recognising huge impairments due to the pandemic – some of which have subsequently been reversed.

3) Investment trust premiums/discounts

Given the possible distortion of historical data, our final valuation metric is based entirely on market sentiment.

Investment trusts are stock market traded funds. They’re closed ended, which means the number of shares in issue is fixed. The shares can trade at a premium or a discount to the underlying net asset value of their holdings.

There are times therefore when you can buy investment trusts for less than the value of their underlying investments – when they’re said to be trading at a discount. That tends to happen at times of market stress – when lots of investors might be selling. But there are also times when investors will pay more for an investment trust than their underlying holdings are worth – known as trading at a premium.

In the graph below, we’ve taken the average premium or discount of UK listed investment trusts back to 2005 (again the earliest date from which data is easily available) and compared that against average stock market returns over the following ten years.

Chart showing Investment Trust premiums/discounts and subsequent 10 year UK stock market returns

Scroll across to see the full chart.

Past performance is not a guide to future returns. Source: Refinitiv, 24/05/21.

The relationship isn’t as strong as for PE ratios or dividend yields, but it’s still there. When investment trusts have traded at large discounts to their underlying book value, stock market returns over the following ten years have tended to be stronger.

UK listed investment trusts are currently trading at an average 14.4% premium to their book value. Over the limited timeframe we’ve looked at, when the market’s been in this region before, it’s gone on to return 57.0%, or 4.6% annually on average.

Should I invest in stocks and shares?

All three value indicators we’ve looked at above suggest investors could be in line for lower than average stock market returns over the next ten years. Of course, none of these returns should be taken as in anyway guaranteed, and the future will be very different to the past.

However, does this potential for lower returns mean investors should be avoiding UK stocks altogether? We think not. If you’re not going to invest in stocks and shares, then you have to put your money elsewhere. While stocks and shares might not be attractive by historical standards, the outlook in other asset classes doesn’t look much better and in some cases is even worse.

Even at current valuations, for investors willing and able to take a long-term view, stocks and shares should be a key consideration. After all it’s about time in the market, not trying to time it.

This article isn't personal advice. If you're not sure if an investment is right for you, get advice.

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