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Is the Market Overheated Now?

With 2019 off to strong start, many stocks have regained most of the losses they incurred back in the fourth quarter of 2018. The bounce back has led some market commentators to suggest that markets may start to lose steam. 

With that said, here’s my take on whether the local stock market is currently overvalued and what investors should do about it.

Market valuations

Perhaps the best indicator of an overheated market is when stock prices are out of sync to their intrinsic values. Back in 2007, stocks in the Straits Times Index were trading at average price-to-earnings multiples close to 21. Those were lofty valuations, which led to the deep sell-down the very next year.

As of March 2019, the STI SPDR ETF (SGX: ES3), which mirrors the Straits Times Index, had a price-to-earnings ratio of 12.2 times. This ratio suggests that the Singapore stock market, in general, is still a fair distance away from the lofty prices of the pre-crisis period in 2007.

Earnings growth

Looking at the price-to-earnings multiple in isolation does not paint a complete picture. Investors need to look at the potential earnings growth and what lies ahead. If a company’s earnings are expected to grow, it makes sense for market participants to attach a premium to its valuation.

A useful way to assess if a company is fairly valued is to take its earnings divided by its 5-year earnings growth forecast. This will give you the company’s price-earnings-growth (PEG) ratio, which will provide a better picture of the company’s valuation. Legendary investor Peter Lynch prescribed looking for companies that had PEG ratios below one.

It is difficult to estimate the market’s overall earnings growth, so investors will have to look at individual companies to see if they are priced reasonably or not.

There will always be stocks to invest in no matter the market conditions

At any given time, there will always be over-optimism that drives certain stocks up and unreasonable negativity that drives some down. This creates a market inefficiency that leads to a divergence of stock prices from their intrinsic values.

General market optimism can also drive stocks up as a whole in bull markets, but that does not mean every stock in a bull market is overvalued. Inefficient markets and short-term thinking will provide investors with plenty of opportunities in any market condition.

The Foolish bottom line

The price-to-earnings multiple of the Singapore stock market as a whole certainly does not seem overly stretched based on historical data. Investors should also be heartened to note that despite the potential headwinds from the Sino-U.S. trade war, regional and global economies are still expected to grow this year, which will likely propel business earnings. 

However, the key takeaway here is that instead of worrying about how the overall market is doing, investors should concentrate on the fundamentals behind individual companies and their current valuations when making investment decisions. By focusing on a bottom-up approach, savvy investors can spot bargains in any market conditions.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.