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Stocks Are Overvalued: What Should We Do?

According to the latest research results compiled by the giant investment management firm GMO Capital, which oversees US$112b in assets, the American stock market is overvalued.

In GMO’s Nov 2013 quarterly letter, Ben Inker, co-head of asset allocation at the firm, wrote that the fair value for the S&P 500 index in the USA “is about 1100 and the expected return is -1.3% per year for the next seven years after inflation.”

For some perspective, the index closed at 1,781 points yesterday and it would take a 38% decline for the S&P 500 to return to GMO’s estimation of its fair value.

That sounds bad, doesn’t it?

But the thing is, if you’re invested in shares of individual companies, the level of an index – though important – shouldn’t be the prime focus. Individual shares can, and often do, find themselves at different spectrums along the ‘valuation scale’.

Let’s take a look at what it’s like back home in Singapore.

The Straits Times Index (SGX:^STI) is currently at 3,161 points and valued at less than 13 times earnings based on the data provided by the SPDR Straits Times Index ETF (SGX: ES3), an exchange-traded fund that tracks the STI.

At this level, our local index’s valuation can be said to be at a “Goldilocks temperature” – not too hot and not too cold.

But based on the price to earnings (PE) ratio itself, we find some small caps like UPP Holdings (SGX: U09) – which has interests in paper mills and a power generation plant in Myanmar among other businesses – carrying a sky-high trailing PE of 352.

On the other hand, we have big caps like the local bank DBS Group Holdings (SGX: D05) selling for a below average trailing PE of 10.5.

Granted, the PE ratio might not be the perfect measure of value in shares, but it serves to illustrate how there can be a big discrepancy between how expensively or cheaply valued individual shares can be, regardless of where the overall market index is at.

And, when shares of individual companies are cheap based on their own contexts, they can often do well even if the index crumbles.

The STI’s still down by close to 20% from its peak of 3,876 points that it flirted with on 11 Oct 2007 before the Great Financial Crisis went into overdrive. But, in the six years since, we have had some notable blue chips and mid-caps that have gone on to do very well.

One such example’s the conglomerate Jardine Cycle & Carriage (SGX: C07). Despite its recent troubles, it has seen its price climb 70% from 11 Oct 2007 as its earnings ballooned from US$224m in 2006 to US$828m in the last 12 months.

Individual companies can, and do often, travel very different paths from that of a market index. As investors, we should bear that in mind the next time we think about whether the market, as a whole, is undervalued or overvalued.

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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.