What to expect of the market in 2016?

Based on 31 Dec 2015 Straits Times Index (STI) closing of 2882.73, I have calculated that the implied equity risk premium (ERP) is 4.98%. This means that for investors whom want to invest in the market, the market must be returning at least 4.98% above the risk free rate. The risk free rate which I used is 2.50% based on the Singapore Government Bond 10 year yield. How did I calculate the ERP? I simply treat the problem as a discounted cash flow model. The price of the index is simply the net present value of future cash flows. Cash flows here is in dividends and share buybacks done by the 30 companies of STI in 2015 and I assume this cash flow will grow at 5% for the next 4 years and a terminal growth rate of 2.5% (equals the risk free rate). Thereafter I apply a discount rate to these cash flows to derive the price i.e. the index level. Deducting the risk free rate out of the discount rate, I will obtain the ERP. 

The cash payout of earnings done by STI companies in 2015 is 60% and I assume that this stays constant. Interesting to note is that for S&P 500, the cash payout in 2015 is 101.5% of earnings, which is unsustainable over the long run. Potentially we could see S&P 500 correcting in the near term. With this information, we will only need to solve for the discount rate. This discount rate is the total return that investors are expecting. Implied ERP is then obtained by deducting the risk free rate. Therefore for investors based on the start of 2016, they are expecting a total return of 7.5% by investing into the stock market.

As of 31 Dec 2015, the trailing twelve months (TTM) price-earnings (PE) ratio of 13.78x and a forward PE ratio of 13.1x, this represents a good opportunity to start accumulating at the market.

Moving two weeks into 2016, the STI ended at 2630 on 15 Jan 2016. ERP at this level has increased to 5.46% and PE ratio has gone to 11.98x. This means that comparing to PE ratios over the past 8 years, a DBS report, the average 12 month forward PE is at 13.74x and as of 15 Jan 2016, the forward PE ratio of 11.98x has crossed 12.2x (-1SD) FY 16F PE. In statistics, this means that we are about 68% confident that the true PE ratio lies between the upper (15.25x) and lower limit (12.2x) of PE ratios. The implied forward ERP of 5.46% is also in the similar statistical range of PE ratio as the earnings are similarly used. This means that STI is getting more undervalued as of 15 Jan 2016. If you are still not convinced, one can compare a longer period by using the historical ERP over the past 20 to 30 years and decide a fair ERP. I do not have the longer history data on hand, probably a Bloomberg terminal might help getting the information easily. Also to note, ERP is a key to calculate the cost of capital thus a higher ERP tends to undervalue stocks.

An interesting insight to note here is that the 2SD away from the average 12-month forward PE is between 16.71x and 10.66x. This means we are 95% confident that the true PE ratio lies in this range. At PE 10.66x, the implied forward ERP is 6.12% and the index will be 2340. This is about 11% drop from 15 Jan 2016 closing of 2630. I do not foresee that we will be heading to this level this time, but if we really do, it will be one of the rare chances to buy stocks at a bargain.

To give you some comparison, the US implied equity risk premium is pretty comparable to Singapore’s due to both countries sharing the same currency sovereign rating of Aaa. Therefore some analysts and practitioners have interchangeably used both ERPs. 

Referencing the above to Prof Damodaran’s compilation of implied ERP on the US equity market posted on his blog, the US ERP as of 2015 is about 6%. S&P 500’s 2015 cash payout is 101.5% of earnings therefore it makes sense that US’ ERP is higher than what I have calculated for Singapore’s.

What I would like to note is that the 75^th percentile of US Equity Market implied ERP from 1960-2015 is 4.93%. This means that Singapore’s current implied forward ERP of 5.46% does signify optimism for STI in the near to medium term and supports my call to start accumulating Singapore stocks.

On a side note, I have also read some recent Howard Marks' memo and on his latest on 19 Jan 2016. I agree with him that the market is a compilation of all investors’ (from your big institutions to men on the street) actions. And these actions are based on predictions going forward and these predictions tend to be swayed by emotions which affect the market strongly in the short term. In the long term, the fundamentals should prevail.

Markets can be right at times and wrong at others. It is always best to take action when the market is wrong. I think now is the time.