The FTSE is massively overvalued: those selling are behaving rationally

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I have already noted market reaction to the bank bail out this morning. It is clear that £500 billion is not enough to stabilise markets. There are sound reasons for thinking this.

Net dividend yield on the FTSE 100 was about 4.6% at the end of September. Of course it has risen since then: the market has gone down by about 15% (give or take). That pushes the yield to over 5%, but that's based on last year's dividends. There is no way dividends will be that high across the market this year and the prospect of capital growth is quite clearly remote: we are heading for a recession. Any growth prospect has therefore to be massively discounted right now.

All this means that for now dividend yield is the only reason for being in the market. And when cash is paying higher rates than Stock Exchange dividend yield with UK banks now near nationalised and therefore offering effective guarantees on deposits the only possible direction for the FTSE is down. So the question is how far down?

It's notable that the Treasury is looking for a return of more than 10% on its investment in the banks. That's quite reasonable, maybe low even, partly because there is no real upside potential. Maybe with a long term prospect of gains this could be discounted a little: maybe 8% on ordinary shares is a rational expectation now. In 1975 when we last got to this position the dividend yield reached 10%.

But where does that leave the index? Based on data for September 2008 and requiring this rate of return to compensate for current risk the rational value of the index would be no more than 2900. I can't see it settling above that right now. In other words, the fall has some way to go as yet as the fundamentals have not been corrected for at the moment, and it could get worse still before any bounce begins.

Of course if the banks were taken out it might not get that bad - but that would require nationalisation. Which might be an argument for doing it. They're too toxic to be in the index or the market right now, so why not accept that as a reality and bring them under the control of the state, which is the only place for them at present.