It's All About Timing, Believe It Or Not!

Equity risk premium model suggests there is now more upside potential in the Singapore stock market than its Malaysian and American counterparts.

Three months back, I presented a model for timing the stock market using what is called the equity risk premium (ERP). Based on data in the last 15 years, I found ERP to work supremely well for the Singapore market. But is it a one market wonder tool? Does it work for other markets as well?

I tested the model on the Kuala Lumpur Composite Index and Dow Jones Industrial average and found ERP to be almost as good a timing tool for KLCI and the Dow.

What is ERP? Just to recap, I defined ERP as stocks' earnings yield minus the risk-free rate. Earnings yield is obtained by taking the inverse of the market index's price earnings ratio. For Singapore and Malaysia, the one-year fixed deposit rates are taken as the risk-free rates while in the US the one-year Treasury bill is deemed risk free.

ERP is the compensation investors require for holding stocks. When the economic outlook is bad, or in the aftermath of a catastrophe, the ERP will be high because fear grips investors and they can only be enticed to hold 'risky' stocks if the promised returns are good.

Conversely, in good times everyone becomes over-confident of the continued good performance of stocks and will demand very little compensation to hold them. Thus ERP can be used as a sentiment gauge for stocks which also would suggest to us the relative over or under-valuation of stocks based on the established patterns of the past.

The findings Because of the difference in interest rates in the three countries, the ERP calculated also vary. So do the levels of ERP at which one buys or sells stocks. Based on the ERP for the three countries, it appears that Singapore investors are the most risk averse, requiring a relatively high premium for holding stocks. Another way to look at it is that, theoretically, it should be potentially more rewarding for Singaporeans to hold stocks than to put money in fixed deposits (FD).

One reason for the high ERP for the Singapore market is its low FD rates. Over the last 15 years, the average one-year FD rates in Singapore is only 3.9 per cent. This compares with Malaysia's 6.2 per cent (over the last 13 years) and 5.7 per cent for US (over the last 16 years).

The lengths of study periods are constrained by the availability of data from the database of Thomson Financial Datastream. Given a same market PE ratio, the lower the risk-free rates, the higher the ERP and the greater the incentive should be to hold stocks.

In Singapore, due to a consistently low interest rate environment, it has been observed that in the past 15 years, once market neared an ERP of 3.5 per cent or (350 basis points), it was a good time to gain exposure to stocks. When ERP falls to 60 basis points, it usually indicated stocks prices had overshot on the upside and it was time to hold cash.

For the Malaysian market, ERP of 100 bps had proved to be a profitable level to get into equities and -250 bps to sell. For US, it was a buy at 100 bps and a sell at -200 bps.