Time To Pile Into Stocks Now?

Market rose by 40-200% on 4 occasions in the past 15 years when conditions were similar to the present.

Stocks bonds or cash? How much you hold of each asset class or asset allocation - is the most important decision in an investment process. Studies have shown that about 95 per cent of variations in returns on portfolios are explained by asset allocation decisions, Only about 5 per cent are due to other causes, such as security selection.

How best to allocate your funds? To a certain extent, that depends on your risk appetite, which in turn hinges on your individual circumstances. A risk-averse investor may hold more cash, and a risk-tolerant investor vice-versa. Allocation will also depend on market conditions.

Even if you have high tolerance for risks, it would be foolish to allocate 80 per cent of your portfolio to equities during a stock market bubble. And even if the market was "normal" when you allocated your assets, prices will move, leaving you holding more of one asset class than you desire. In which case, you might want to rebalance your portfolio.

For instance, say your initial target was 60 per cent stocks, 30 per cent bonds and 10 per cent cash. Luckily for you, there was a bull run and your stocks appreciated significantly. Now, stocks make up 90 per cent of your holdings. A normal rebalancing will require that you sell down your stocks, buy bonds and increase cash so you maintain your 60-30-10 mix.

When is the market over-valued? The stock market moves in a cycle - from extreme optimism to extreme pessimism. And it has been shown that short-term movement of funds to take advantage of perceived over or under-valuation of securities in different asset classes can yield spectacular results.

But how can you tell when stocks are under or over-valued vis-a-vis bonds or cash? I have looked at what is called the equity risk premium - the compensation investors require for holding stocks - and found it to be a superb indicator.

When the economic outlook is bad, or in the aftermath of a catastrophe, the equity risk premium 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.

Using historical data, I estimated the equity risk premium by taking the inverse of market price earnings ratio - or earnings yield - minus the riskfree rate. Market PE ratios were obtained from Thomson Financial Datastream and one-year deposit rates were taken as risk-free rates.

There was clearly an inverse relationship between stock prices and the equity risk premium between 1987 and 2000. Every time the risk premium measured in basis points - hit 350, it was an indication of under-valuation of equities. On the other hand, a drop to about 60 points suggested that the market was over-valued.

Between 1987 and 2000, the equity risk premium hit and exceeded 350 basis points four times - in December 1987, September 1990, July 1992 and September 1998. And each time, the stock market rebounded by about 40 to 200 per cent in the subsequent nine to 15 months.

By then, the risk premium would have fallen to about 60 points, suggesting equity prices had run too far ahead. This signal of over-valuation appeared in September 1988, June 1991, November 1993 and January 2000.

Assuming you had increased your equity holdings to 100 per cent when the equity risk premium rose to 350 basis points, and reduced your holdings to zero when it fell to about 60 points, your $100 portfolio in January 1987 would have grown to about $1,381 in January 2000.

Taking this approach, you were only invested in the market in about five of the 14 years. Your investment periods were from December 1987 to September 1988, September 1990 to June 1991, July 1992 to November 1993 and September 1998 to January 2000.

You would have avoided the "Black Monday" October 1987 market crash, the Asian crisis and the implosion of the Internet bubble.

Sept 11 shock In the first week of January 2000, near the peak of the Internet bubble, the equity risk premium said you should exit the market. Had you done that, your portfolio would have returned a spectacular 20.6 per cent a year compounded annually since 1987.

This compares with the $320 you would have made - an annual return of 8.7 per cent - had you stayed invested in stocks from January 1987 until January 2000.

At the end of February 2001, the equity risk premium again rose to 350 basis points, suggesting the stock market was undervalued once more. At that time, the Straits Times Index was 1,937 points.

Should you have ploughed your entire portfolio of $1,381 into the market? According to the theory, yes. But the unforeseen Sept 11 shock caused stock prices to fall through the floor. And today, with the STI around 1,800, your $1,381 would have dwindled to about $1,283.

Still, that's almost 13 times more than your original $100 investment, or a compounded annual return of 18.5 per cent. On the other hand, a buy-and-hold strategy from 1987 would have given you a portfolio worth only $228 today, or annual compounded growth of just 5.7 per cent.

But there are sustained periods when markets are under or over-valued. For example, the equity risk premium indicated that the market was overvalued for much of 1987 and between late 1993 and mid-1995.

Strict followers of this theory must therefore be disciplined enough to resist the temptation to jump into the market in those periods, when newspaper headlines screamed about the record-breaking feats of the STI every day and practically everybody you know was making oodles from the market.

There have also been stretches of continued under-valuation - such as in late 1990 to early 1991 and in the second half of 1992. Say you had taken the cue given by the equity risk premium and invested all your money in the market at the beginning of those periods?

Well, you would have been horrified - because the market continued to slide. But if you had gritted your teeth and hung on, as subsequent historical data shows, you would eventually have been generously rewarded.

Stocks or cash now?

Now the big question. What does the equity risk premium tell us at present? The number is signalling that the Singapore stock market is still under-valued by historical standards. It has been so for almost two years now - the longest period of depressed pricing in the last 15 years. Of course, this won't be the case if corporate earnings plunge this year and next.

But if you (a) don't believe this will happen, (b) are convinced of the equity risk premium theory and (c) have a medium to long-term investment horizon, you may want to increase your allocation to equities.

As usual, the obligatory caveat applies. The simulation rests on history and may not represent the future. Also, if too many people in the market start to track and act on indications given by equity risk premium, the market will self-correct faster and the cycle will not be as pronounced. The spread of 350 basis points as buying level and 60 points as selling level may become narrower.