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How Much Further Can The STI Rise?

The Motley FoolThe two most powerful people in the global financial arena can’t both be right. One of them has to be wrong. But which one could it be?

Janet Yellen, the chair of the US Federal Reserve, in her semi-annual Monetary Report to the Congress, told American lawmakers that a wide range of assets including stocks, bonds and property had risen. However, she also pointed out that they remain generally in line with historic norms. In other words, asset prices were not in bubble territory, yet.

Compare Janet Yellen’s appraisal of the markets with that of Christine Lagarde who is the head of the International Monetary Fund. The managing director of the IMF warned that financial markets maybe too upbeat, given the high levels of unemployment and debt in European economies. She added that continuing low inflation could undermine growth within the European economy. In other words, investors might be a bit too exuberant.

Rarely, do government officials or appointed members of international monetary organisations speak out about stock market valuations. Some might even argue that it is not their place to comment about the stock market, if at all.

But that has not stopped Janet Yellen or Christine Lagarde from giving their two pennies’ worth about how investors should be allocating their assets. Trouble is, when high-profile commentators such as Yellen and Lagarde express opposing views about the market, they only succeed in confusing investors even more.

So, are stock market prices in line with historic norms, as suggested by Janet Yellen or are investors, according to Christine Lagarde, being too upbeat?

The answer probably lies somewhere between the two. Currently, the Singapore stock market, as represented by the Straits Times Index (SGX: ^STI), is valued at about 14 times profits. In other words, investors are paying around S$7 for every dollar of profit that Singapore companies make collectively.

To put it another way, if all the companies in the Singapore stock market paid out all their profits to shareholders, investors would, in theory, earn around 7% on their investments. That is not too expensive when compared to the returns from government bonds. In the US, the 10-year Treasury is yielding 2.5%.

Dividend yields paint a similar picture. Currently, the average dividend yield for Singapore stocks is around 3%. Dividend yields in common with the earnings yield compare well with government bonds, which can be used as a proxy for risk-free investments.

Additionally, by investing in shares, investors could also benefit from capital gains, should share prices rise over time. Or put another way, the total return which comprises capital gains and dividend yields, could be better than lending our money to governments in exchange for the paltry risk-free yield.

However, much depends on what happens with interest rates and the money-printing activities that many central bankers have become addicted to. If easy money continues to be made available, then it is almost inevitable that stock markets could remain favourably priced when compared to government bonds.

But as we all know, central banks cannot make easy money available indefinitely. At some point, they will have to let interest rates rise. They will also have to mop up some, if not all, of the money that they have created. That could, in theory, change the dynamics of the market. But it could also create fresh opportunities for investors.

Interest rates are only likely to rise when central bankers are convinced that the economy is strong enough to tolerate a higher cost of borrowing. That could, paradoxically, bode well for many companies, which might start to see top-line revenues improve and bottom-line profits fatten.

Some might even be persuaded to start deploying the cash hoards they have amassed over the last six years. Ironically, banks such as DBS Group (SGX: D05), OCBC (SGX: O39) and UOB (SGX: U11) could be some of the main beneficiaries when the economy improves and interest rates start to harden.

Higher interest rates could, in effect, widen the difference between the rates that banks charge for loans and the rates that they pay savers, which is one of the main ways that banks make money.

Peter Lynch, one of the most successful investors in our lifetime, once quipped: “When yields on long-term government bonds exceed the dividend yield of the S&P 500 by 6% or more, then that is the time to sell your stocks and buy bonds.

We could be quite some time away from defining moment, yet.

A version of this article first appeared in the Independent on Sunday.

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