There is a way to time the market

21 Jan 2013 10:28
TEH HOOI LING

Use PE ratio as a guide and remove the effects of business cycles

In response to my article last week, on the good it would do to one’s portfolio if one could avoid the 10 worst plunges in the last 40 years in the Straits Times Index, a reader wrote: “I thought it is difficult enough to ‘miss’ one worst day, and now you have to ‘miss’ 10 worst days.

“Who would have this kind of clairvoyance or prophetic ability and also guts to act? It is impossible to be able to have such high conviction to sell all of one’s stocks on the eve of the crash based on your gut feelings that the crash is coming.”

Valid questions. So the underlying question he is asking is: Is there a way to know when to buy and when to sell the market as a whole?

One would need, like the reader said, clairvoyance if the stock market operates in a world of its own, detached from the logic we know that operates in the physical world that we live in. But here is a central truth to the stock market: Underneath it all, there is an economic reality. Companies have to make money in excess of their cost of capital to be of value.

In terms of the assets that the listed companies own, there is always arbitrage around the replacement cost. For example, if you can buy a drinks factory in the stock market for half the price of building one, nobody will build one. Those with money will just buy their competitors’ plants via the stock market.

This will drive up the stock price of drinks factories. When the stock prices rise to such a high level that it is way cheaper to build a new plant instead, a new set of entrepreneurs will come in to build new plants. This will mark the end of the “up” cycle in the stock prices of drinks factories.

Conversely, if you can invest to build something – say fibre-optic cables – for $1 and sell it for $10 in the stock market, then you can guarantee many people would want to do that until we drown in fibre-optic cables. This is exactly what happened in 2001 and 2002.

We keep reading it, but it is true: Greed and fear of market participants drive stock market prices to the two ends of the spectrum.

This week, I will show that there is a way to tell when the market is over or undervalued. And it is not based on your gut feelings.

Remember, we talked about using price-earnings (PE) ratio – how many times a stock is trading relative to its earnings – to value stocks. We can use this metric to value the entire market as well.

But there is a problem with using the PE ratio without regard to business cycles. For a cyclical stock say, shipping company NOL, if it is at the peak of its cycle, yet you are still willing to pay 20 times earnings for the stock, then you are set to suffer a substantial capital loss on your investments. Because the earnings will come down, and the PE of the stock will rise sharply, say to 40 and 50 times, and the market will deem it too expensive. Its share price will then drop.

Conversely, at the bottom of the cycle, you could pay 50 or 100 times for NOL and you could conceivably consider it a cheap buy.

So in valuing the market using the PE, we need to remove the effects of business cycles. One way to do it is to take the average earnings of the market in the past 10 years, and compare it to the current price of the market.

That’s what I have done in the accompanying chart. The Straits Times Index (STI) data from Thomson Datastream started in early 1973. So the first point of the PE starts only in 1983 – 10 years later.

http://www.btinvest.com.sg/system/assets/10462/0197e7c1-page-001.jpg