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Why a 3,800 Straits Times Index or 16,000 Dow Doesn’t Matter

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Over the past week or so, the three major American stock market indexes, namely the Dow Jones Industrial Average, the S&P 500 Index, and the NASDAQ, all broke through round-numbered barriers of 16,000, 3,800, and 4,000 respectively.

In particular, the 16,000 and 3,800 points level for the Dow and the S&P 500 represented all-time highs for them. With the NASDAQ, the last time it hit the 4,000 mark was during the speculative-fervour of the dot-com bubble days in the late ‘90s and early ‘00s.

With the indexes in USA hitting new heights or revisiting bubble-induced peaks, that might naturally lead to fears of market pull backs among investors.

In fact, I was asked recently by an acquaintance about what I thought of the investing-climate over in the USA given such circumstances. In response, all I could muster was to tell her to focus on the underlying corporate results of the index constituents.

What do I mean by this? Well, it’s easy to look at the index and forget that it’s actually made up of a basket of shares, each with their own underlying fundamentals.

This results in each market index having its own price to earnings (PE) ratio, price to book ratio, etc. – think of an index as a collection of businesses that are each generating sales, profits, and cash flows with their own set of assets.

When thought of that way, how high or low an index’s price level is becomes meaningless unless its underlying fundamentals are brought into context.

Let’s have some hard numbers to have a better idea of what I’m talking about. The NASDAQ first crossed the 4,000 mark back in 29 Dec 1999. Here’s how the index’s fundamentals looked like in the past compared to now:

29 Dec 1999 26 Nov 2013
Price Level 4,041 4,018
Price to Normalised EPS 74 30

Source: S&P Capital IQ

So, based on its normalised PE ratio, the NASDAQ is actually more than twice as cheap as it was back in 29 Dec 1999 despite being at a similar price level.

Similarly, any discussion on the Straits Times Index’s (SGX: ^STI) price level would be meaningless without comparison with its underlying fundamentals.

Singapore’s stock market bellwether is currently at 3,172 points and using data from the index tracker SPDR Straits Times Index ETF (SGX: ES3) as a close proxy, it has a trailing PE ratio of around 12.5.

The STI is still someway off its high of 3,876 that it reached back on 10 Oct 2007, before the Great Financial Crisis of 2007-2009 went into full-swing. Should investors be worried if the index ever revisits its old peak?

That would really depend on the fundamentals of the index at that point in time. Even if the STI were to magically jump 22% overnight to hit 3,876, it would still be selling for around 15 times earnings only, which really can’t be said to be exorbitantly expensive.

On the other hand, the STI can be expensive even if it stays stagnant at its current price in a situation where its constituents – consisting of some of the biggest companies in Singapore, like telco giant SingTel (SGX: Z74) and South-East Asia’s largest bank DBS Group Holdings (SGX: D05) – see their earnings fall like a swatted fly.

So, while the chatter about the price levels of market indexes can make for good small talk, it can be meaningless for investors when discussed in a vacuum without their underlying fundamentals being brought into context.

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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.