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One Great Way To Look At The Market

Over in the USA, there has been chatter about how the stock market is over-valued and primed for a fall, judging from the CAPE valuation measure developed by Yale University economics professor Robert Shiller.

CAPE’s an acronym that stands for “Cyclically Adjusted Price-Earnings Ratio’. The current price or points-level of a market index is divided by the average of its inflation-adjusted earnings over the last 10 years to come up with CAPE.

For some trivia and history, Benjamin Graham, the intellectual founder of value investing was the first to come up with such a valuation measure – Graham used the average earnings over the past 10 years that weren’t adjusted for inflation, unlike Shiller – but it was Shiller who popularised its use and named it as CAPE.

Historically, CAPE, when used on the S&P 500 Index (a broad measure of the American stock market), has averaged about 16 since 1871. Today, it’s slightly north of 24, signalling that the US market’s ‘overvalued’ by quite a fair bit.

This has made some market-watchers over in the USA jittery, thinking we might be seeing pullbacks soon (the problem with this fear though is this: since when has there not been a pullback? Prices going down and then up and vice-versa are as natural as night follows day and there shouldn’t be fear. If prices fall, investors with an eye out for bargains should clap their hands together in glee instead!)

Back at home, it was just two Sundays ago (22 Sep 2013) when the Straits Times Index (SGX: ^STI) was singled out by a writer from our national paper The Straits Times as carrying valuations that “are also well above historical averages”.

Though I find The Straits Times’ writer’s point contentious – the STI’s PE ratio is around 13 as of 26 Sep (if we use the STI-tracker SPDR STI ETF’s (SGX: ES3) data as a close-proxy), which is still somewhat lower than the STI’s long-run average PE of around 16 – it does point to the prevailing fear that stocks are due for a fall as a result of them them being expensive.

But here’s where market participants are perhaps getting it wrong. Despite the importance of market indices in telling us whether the market looks cheap or expensive, if you’re an investor in individual businesses (like what we mostly do at The Motley Fool Singapore), then it might be better to forget about what the market’s doing.

For most stock pickers, we’re out looking for businesses that are trading at discounts to their intrinsic value. Different shares can move in disparate directions compared to the prevailing market index at any given time, creating a situation where they might be undervalued or overvalued despite the general market’s value-proposition.

Since the start of the year till 29 Sep 2013, we’ve seen telecom operator Starhub (SGX: CC3) gain 17.6%. On the other hand, we have companies like Indonesian palm oil producer Golden Agri-Resources (SGX: E5H) losing 20% in the same period. Meanwhile, the STI remains essentially unchanged from where it was on 2 Jan 2013.

Some investors might point to Golden Agri trading at 0.6 times its book value at its current price and think that it’s cheap while focusing on Starhub’s trailing-12-months’ PE ratio of 19.7 and conclude that it does not present much of a bargain. All this is happening concurrently with the STI carrying a valuation (based on its PE ratio) that’s only slightly lower than its long-term average.

Can you see how different Golden Agri and Starhub’s price-to-value relationship can be, as compared to the market’s?

I’m not necessarily trying to say that Golden Agri’s cheap and that you should rush out to buy it or that Starhub’s expensive and that you should sell it. Instead, I’m trying to point out that looking at the STI alone tells us nothing about whether a particular company’s a bargain, just as the STI’s not saying much about the valuations of the palm oil producer and telco operator.

Foolish Bottom Line

It will likely be true that if a broad market index’s really cheap, there’ll be more bargains to be found. But that doesn’t mean that the share you want is available at an attractive price in relation to its value.

So, look at the market’s general movement if you want, but don’t get fixated by it. You might just find out that not being overly-focused on where the market’s going is actually one great way of looking at it.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.