Amid the fallout from the US sub-prime crisis and the ensuing tightening of liquidity around the world, investor sentiment is expected to remain fragile
THE remarkable thing about the bull market of the past four years is that despite stock prices having run up by 160-plus per cent, the valuation of the Straits Times Index is still not excessive. The reason, of course, is that corporate earnings have kept pace with the share price increases.
Followers of this column will be familiar with the concept of equity risk premium (ERP), which I've written about on several occasions.
ERP is the compensation above the risk-free rate that investors require to hold equities. It is a measure of investors' exuberance or risk aversion. In a bull market, when all investors are chasing stocks, ERP falls. A low ERP implies that investors are willing to accept low returns to hold equities.
In a depressed market, when nobody wants to buy stocks for fear of further losses, ERP will be high. A high ERP suggests high expected returns from exposure to equities.
I estimate ERP by taking the difference between the earnings yield of the Straits Times Index or STI - the inverse of its price-earnings ratio - and one-year interbank offer rates.
Tightening liquidity
So in essence, ERP captures the market's valuation in a single number. It takes into consideration the current market price, relative to earnings, and the risk-free rate.
Between 1990 and now, based on market earnings multiples as calculated by Thomson Financial Datastream, the Singapore market's ERP ranged from a high of 7.94 per cent in the last quarter of 2005 to a low of -1.63 per cent in February 1998.
As mentioned, a low ERP means low expected returns and high ERP means high expected returns. From February 1998, when ERP was in negative territory (which implies that investors are willing to lose money holding on to equities), the STI plunged 44 per cent in the following seven months.
From November 2005 when ERP was a high 7.94 per cent, the STI has climbed 55 per cent since.
But despite price levels having climbed that much in under two years, the current ERP is still a relatively high 5 per cent.
This is helped by two factors. One, corporate earnings have accelerated. And two, risk-free rates - as measured by one-year Singapore interbank rates - have remained benign.
The ERP level now is lower than the 7.29 per cent registered in February 2003 or the 7.94 per cent in November 2005.
Still, a total return of 7.5 per cent a year for holding equity - ERP of 5 per cent plus risk-free rate of 2.5 per cent - is nothing to sniff at.
Of course, the number will hold true only if the conditions existing today remain so going forward.
Amid the fallout from the sub-prime mortgage crisis in the US, and the ensuing tightening of liquidity around the world, will conditions remain benign going forward?
I've decided to do a sensitivity analysis for the STI under various assumptions.
The STI's current level of 3,359 points is in an environment where the interbank rate is about 2.5 per cent and investors' risk aversion relatively high, with ERP at 5 per cent. The assumption is also that there will be no earnings growth. So the questions that have to be asked are:
One: Will investors continue to be spooked by the uncertainty in the market? If so, ERP will remain high and may climb further. This will mean further declines in share prices.
Two: Will the liquidity crunch remain and eventually drive up risk-free rates? If yes, that's bad news for stocks and shares.
And three: Will a higher interest rate environment and eroding consumer confident lead to a slowdown in the economy and corporate earnings? If yes, there will be more downside to stock prices.
Here are the numbers. Assuming that investors: 1) remain at the current level of risk aversion, that is, ERP at 5 per cent, 2) the drying up of liquidity leads to interbank rates climbing to 4 per cent from the current 2.8 per cent, and 3) corporate earnings decline 10 per cent next year, then fair value for the STI would be around 2,580.
These are rather drastic assumptions, and based on what we are seeing today, a quite unlikely scenario.
On the other hand, if investors' jitters are assuaged as the picture emerges that the US sub-prime woes will be relatively contained, and 1) ERP falls to 4 per cent; 2) liquidity becomes tighter and interbank rates rise to 3.5 per cent; and 3) earnings are mixed and flat overall, then fair value for the STI would be around 3,435 points.
Buying opportunities
My sense is investor sentiment will remain fragile, so ERP will remain at a relatively high level for some months to come. Many will be monitoring the performance of the world's underlying economy. And it would appear that growth momentum in the likes of China and India will not be too stunted by the current financial turbulence.
This is the view still held by many analysts. Morgan Stanley's Australian analyst Gerard Minack wrote this week: 'For now, growth momentum seems high, outside the US. My view remains that there will be one more rally in equities, and that, while difficult to pick the trough in the current turmoil, there will be a buying opportunity.'
Share Oliver, head of investment strategy and chief economist of AMP Capital Investors, wrote: 'While the ride is likely to be rough over the next few months and further declines are possible, the recent slump in share markets should not be seen as the start of a bear market.
'The low inflation global economic expansion is likely to remain intact. While growth has shifted away from the US to the rest of the world, the global interest rate backdrop remains benign, the corporate sector is in good shape and share markets are not over-valued.
'The historical record indicates that corrections up to 20 per cent are not unusual in the context of cyclical bull markets and so investors should not get too alarmed by the recent turbulence. Corrections are healthy in the sense they ensure share markets don't get too exuberant.'
The writer is a CFA charterholder.
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