Gauging the market through equity risk premium

Following the stock market rally since mid-March, STI has now breached the 200day MA level on the back of rising volume. I would say that the majority of stocks regardless of size, have rebounded off their lows. All technical signs are pointing towards a bullish uptrend.

In this posting, lets take a look at what the equity risk premium (ERP) is indicating for the Singapore market. To calculate the ERP, the average P/E of the index stocks are needed. Curently there are 30 component stocks which make up the STI. Based on their Y2008 earnings and the closing price on 8th May, the average P/E is found to be 10.9. Take note that 2 companies have got no P/E as they are loss-making.

The second input we need is the average 1-year fixed deposit rate of the 3 local banks. A quick search on the internet will provide the rates and the average i get is 0.55%. Using the average P/E and average FD rates, the ERP is found to be 8.63%.

One thing i would like to point out is that the ERP value is never static. It changes everyday due to the fluctuation of stock prices. Generally, a high ERP value (>2) indicates that the investor expects a higher return for putting his money into equities especially during periods of uncertainty. In order to make investing in equities worthwhile, the investor must be adquately compensated through earning higher returns. On the contary, it goes down when investors are bullish about the future prospects of equities.

The current ERP of the STI is relatively high as compared to one, two years ago. As such, the Singapore market is not considered to be expensive. However, bear in mind that trailing P/E is being used. A 20% drop in earnings this year for market is not far-fetched. As investors, we should never rely on a single metric to determine our buy or sell decisions. Even though the Singapore market is not expensive, whether it can still continue to go up is anyone's guess.