“No price is too high for a bull or too low for a bear” – an old Wall Street proverb
It is a known fact that investors can be over-optimistic or over-pessimistic at times. When a series of good news happens, investors switch into the optimistic mode, often over-optimistic, and significantly bid up the price of a stock ditching any rational pricing theory whatsoever. Any high price will be justified by reasons like “profit will continue to grow” or even worse, “the price will simply continue to rise”. Conversely, when a series of bad news happens, investors will go into the pessimistic mode and nothing can make us feel it is worth buying.
I am also guilty of this. This is why I added a new feature to SGXcafe to (hopefully) help me stay rational during times like these.
The question is: how do we identify over-optimism or over-pessimism?
Typically, when the market is optimistic, investors are willing to pay more per dollar of earnings, pushing the Price over Earnings (PE) value up. On the contrary, when the market is pessimistic, investors are less willing to pay per dollar of earnings, dragging the PE value down.
Therefore, to differentiate whether the rise (or fall) in price is due to change is earnings or simply the change in investors’ mood, we can compare the long-term PE-200 that the stock has been transacting at against the short-term PE-20. By using the long-term PE as the baseline, we assume it is the “true” PE that a rational investor should be paying for that stock. Although this is not perfect, it is reasonable enough in my opinion.
When PE-20 is significantly higher than PE-200, then it is likely that we are over-optimistic.
When PE-20 is significantly lower than PE-20, then it is likely that we are over-pessimistic.
I have added this feature for the stock market as a whole, individual sectors (e.g. Service sector) and individual companies (e.g. DBS). Hopefully, this new feature will also be useful to you in assisting you in making your investment decisions.
I am more than happy to listen to your comments and feedback regarding this new feature.
P/S: Recently, investors are pessimistic and hence PE-20 is significantly lower than PE-200. However, since 19 October 2015, PE-20 seems to be closing the gap. This is perhaps an indication that the market is becoming optimistic again? A time to buy?