It was less than a month ago on 12 April 2015 when the Straits Times Index (SGX: ^STI), Singapore’s market barometer, closed at a level above 3,500 points for the first time since December 2007. With the index ending last Friday at 3,452 points – a hair’s breadth lower than 3,500 – should investors be worried about Singapore’s stock market at the moment? After all, high stock prices are an important cause for low returns. But while the index might have only recently hit a seven-plus-year high, a look beneath the hood actually reveals a somewhat different picture. You see,…
It was less than a month ago on 12 April 2015 when the Straits Times Index (SGX: ^STI), Singapore’s market barometer, closed at a level above 3,500 points for the first time since December 2007.
With the index ending last Friday at 3,452 points – a hair’s breadth lower than 3,500 – should investors be worried about Singapore’s stock market at the moment? After all, high stock prices are an important cause for low returns.
But while the index might have only recently hit a seven-plus-year high, a look beneath the hood actually reveals a somewhat different picture.
You see, despite the seemingly high “price” the Straits Times Index is at now, investors might actually be obtaining some solid value at the moment. And that’s certainly not a cause for worry; in fact, it could even be a cause for investors to be optimistic about the future of Singapore’s market over the long-term (I stress the phrase “over the long-term” for a good reason; more on that later).
Seeking value under the surface
In a presentation given on 10 January 2015 at an investment forum, Teh Hooi Ling, the Head of Research at boutique investment management firm Aggregate Asset Management, showed that the Straits Times Index was valued at just 13.7 times its historical average earnings over the past 10 years when it was around 3,300 points at end-2014.
That valuation measure, also known as the Graham and Dodd Price-to-Earnings (PE) ratio, is obtained by dividing a stock’s current price by its average earnings per share figure over the past 10 years; the rational for using an average earnings number over a decade-long period is to smooth out the vicissitudes of the business cycle.
Taken on its own, the Straits Times Index’s 13.7 Graham and Dodd PE at the end of 2014 may not mean much, other than to say that the market’s willing to pay $13.70 for each dollar of profit that corporate-Singapore has made on average over the past decade.
Historical context would suggest though, that the Straits Times Index was cheaply valued at end-2014; Ms Teh pointed out in her presentation that the Straits Times Index’s average Graham and Dodd PE for the three-decade period between December 1985 and December 2014 was 20.8. In other words, the market barometer’s valuation at end-2014 was merely two-thirds that of its long-term historical average.
For even more context from history, the chart below from Ms Teh also shows that the market tended to produce some healthy returns whenever it had a Graham and Dodd PE that’s around 13.7. (If you observe the green and red lines, it would show that the Straits Times Index had produced a median and average compound annual return of around 10% and 12%, respectively, over the next five years whenever the index had carried a Graham and Dodd PE of between 12.5 and 14.5.)
Source: Aggregate Asset Management, with data from Thomson Reuters Datastream
To sum up, this is what the verdict of history had given us at the end of 2014: 1) The Straits Times Index had carried a valuation that was substantially lower than its historical long-term average; and 2) the index had tended to produce some solid returns in the past when it had carried similar valuations.
And given that the index’s price hasn’t changed much between the end of 2014 and today, the conclusions from history I shared above can still be reasonably applied to our current situation.
But buyers’ beware – patience is needed
It should be noted however, that any optimism one might have over our market’s future should be tempered if you’re only looking at a short investing time-horizon – that’s because cheap shares can just as easily give a poor return as a good one if an investor’s time-horizon isn’t long enough.
Source: Robert Shiller; author’s calculations
Let’s look at Chart 1 above. It plots the annual returns of the S&P 500 (a broad market index in the U.S.) against its starting valuation for a holding period of one year. The data utilized stretches from 1871 to 2013, so that’s more than 140 years’ worth of history we’re learning from. As you can tell, the chart’s essentially random – a cheap valuation today offers no protection whatsoever against a poor return, or even losses, one year later.
Source: Robert Shiller; author’s calculations
But see what happens in Chart 2. It’s similar to Chart 1, but with a twist – it plots the S&P 500’s annual returns against its starting valuation for a 10 year holding period. And what a difference that twist makes as a clear trend now emerges: Buy stocks when they’re cheap, and you’re likely to do well over the long-term. It’s certainly not a fool-proof conclusion, but the odds are fairly good that you’d end up doing okay if you had purchased stocks when they were cheap.
A Fool’s take
Given what we’ve seen from Ms Teh’s research and the historical tendency for the market to reward investors well over the long-term when stocks are cheap, it would appear that there’s some cause for optimism – and not worry – with the Straits Times Index now, despite the market barometer having a price that seems to be high.
And to be clear, I’m not trying to forecast anything here – I’m just letting history be a guide.
But in any case, investors ought to note something else that’s important: The annals of history may point toward the Straits Times Index as having a cheap valuation now, but that shouldn’t be applied to individual stocks. At any moment in time, individual stocks can offer vastly different risk/reward characteristics from that of the market. Keep this caveat in mind whenever you invest.
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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 writer Chong Ser Jing doesn't own shares in any company mentioned.