Gazing into the crystal ball

The equity risk premium for STI now is 4%, precariously near the bottom of the last eight years' range.

Mon, Jan 11, 2010
The Business Times
By Teh Hooi Ling
SENIOR CORRESPONDENT

A FEW readers have written in asking me to update my calculations of the equity risk premium (ERP) for the Straits Times Index. The last update on the ERP in this column was more than two years ago. The thing is, since September 2001, the ERP has been persistently high relative to the levels between 1987 until then.


Graphic: Ugraph

Before we go any further, let's recap what is ERP. It is in essence a measure of investors' exuberance or risk aversion. ERP is the compensation above risk-free rate that investors require for holding equities. In a bull market, when all investors are chasing after stocks, the ERP will fall. People will require less and less expected return as they chase after every higher stock prices.

In a depressed market, when nobody wants to buy stocks for fear of further losses, the ERP will climb. That's is when your return from gaining exposure to equities will be the highest.

I estimated ERP by taking the difference between the earnings yield of the Straits Times Index or STI (inverse of its price-earnings ratio) and the one-year inter-bank offer rates. The higher the earnings yield (or the lower the price-earnings ratio of the market) the higher the ERP will be. The lower the bank interest rates, the higher the ERP, and vice versa.

So in essence, the ERP captures the market's over, or under-valuation in one single number. It takes into consideration the current market price, current corporate earnings, and risk-free rate - one of the basic building blocks in valuing an asset.

Between 1987 until end 2001, the range of the ERP for the STI was between -1.9 per cent and 6.5 per cent. The median was 1.6 per cent. Buying the STI when its ERP is -1.9 per cent theoretically suggests that one is willing to lose money to invest in stocks! That would happen when the earnings yield of stocks is lower than what one would get from keeping one's money in the bank. It can be seen as an indication that the market is over valued.

So during 1987 until 2001, buying the STI every time the ERP reached 3.75 per cent and selling when it declined to about one per cent would have yielded a 18.6 per cent annual compounded return by March 2001. That's a performance which beat a lot of fund managers.

However, things changed after 2001. That was when Alan Greenspan cut interest rates to stave off a recession following the burst of the dotcom bubble. With the depressed interest rates, the ERP moved to a higher level. And when the US Federal Reserve moved to raise interest rates in 2004, that coincided with a strong pick up in corporate earnings and a still moderately priced equities. Hence, the ERP has stayed high since.

Between 2002 and now, the median ERP is a whopping 5.7 per cent. Under the old regime, an ERP of 5.7 per cent would have been a screaming buy. And as it turned out, one would not have seen a sell signal at all - going by the old benchmark - as the lowest the ERP ever reached in the last eight years was 3.6 per cent.

For that reason, I stopped monitoring the number. But after receiving e-mails from some readers, I went back to update the numbers. The resulting chart was mind-blowing.

In October 2008, the ERP hit 20 per cent. That was when, according to Thomson Reuters' data, the STI was trading at about five times earnings, and the interbank rate was 1.25 per cent.

Subsequently, the market recovered somewhat, but the ERP was still hovering around 16 to 18 per cent. In March 2009, another leg down in the market brought the ERP back up to 19 per cent. Looking back, we now know that was the buying opportunity of the decade.

So where are we now? According to Thomson Reuters, the historical PE for the STI is about 21 times, and the interbank rate is now 0.625 per cent. Consequently, the ERP is now at about 4 per cent. Going by the forecast earnings for STI component stocks for next year, the forward PE of the STI is about 16.5 times. That would bring the ERP up to about 6 per cent.

Obviously, there is not as much value in the market now. And 4 per cent is precariously close to the lowest level of 3.6 per cent for the ERP in the last eight years or so. And this is at a time when interbank rate is near rock bottom.

But given the assurance from the government of major economies that interest rates will remain low for some time to come, then an ERP of 4 per cent still beats keeping money which earns next to nothing in the bank.

Meanwhile, money supply numbers are decent with November showing growth of about 10 per cent from the year before. The year-on-year change in M1 - namely currency in active circulation and demand deposits - has exhibited a stronger co-movement with stock prices. As you can see from the second chart, year-on-year changes in money supply appears to lead the stock market by some two months.

But admittedly the liquidity we've seen is by no means growing as fast as in 2007. Between March and November 2007, M2 expanded by more than 20 per cent year on year. That was when we saw the STI hitting its record high of some 3800 points.

So in the final analysis, what's the prognosis for the market? Well, it appears there is cause for caution but not alarm as yet. Liquidity and momentum could bring the market further up, particularly in a number of beat-up S-chips. But bear in mind that we are precariously near the bottom end of the ERP range with interest rates now at near zero. Any tightening will make equities ever that much less attractive.

The writer is a CFA charterholder