Equity Risk Premium Model

Ms. Teh Hooi Ling, in "Show Me the Money, Volume 1", recommended the use of Equity Risk Premium model for investment in the equity market.

Equity risk premium (ERP) = Inverse of market PE - risk-free rate

Singapore market
ERP about 350 basis points: market under-valued (Buy signal)
ERP about 60 basis points: market over-valued (Sell signal)

Malaysia market
ERP about 100 bpts (Buy)
ERP about -250 bpts (Sell)

US market
ERP about 100 bpts (Buy)
ERP about -200 bpts (Sell)

Rationale:

ERP is the compensation required by investors for holding risky assets (in this context, equities). Investors demand high returns to be enticed into holding stocks when fear prevails the market. When greed prevails, investors are over-confidence and require very little compensate for taking risks.

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In the book, it was mentioned that the average one-year FD rates (1987 - 2002) in Singapore is about 3.9%. This implies:
Buy when market PE = 13.5
Sell when market PE = 22.2

However, our current 1-year FD rate is only a miserable 0.925% (from UOB website). If we are still looking at 60 abd 350 bpts, that means:
Buy when market PE = 22.6
Sell when market PE = 65.6
O_o!!!

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Although I think it's clearly a good time to accumulate stocks now, I thought it's interesting to see what the current ERP says.

To estimate FY2008 earnings share for STI stocks, latest full year EPS were used for companies with financial year ended 30 June or 30 September. For companies with financial year ended 31 December, full-year EPS were estimated using:
(FY2007 EPS / 9M FY2007 EPS) * 9M FY2008 EPS
Similarly, companies with financial year ended 31 March, EPS for FY2008 were estimated by:
(FY2007 EPS / HY2007 EPS) * HY2008 EPS

Based on yesterday's (11 December 2008) closing prices, estimated PE for Singapore market works out to be 5.28 which means the earnings yield is about 18.93%.

Using 3.9% as risk-free rate (though I don't know where I can get such good deal now), ERP = a hefty 1503 bpts!

No matter how you look at it, it's a STRONG BUY.