I’m interested in individual companies, but I often find myself following the OMX Helsinki PI (Price Index) to gauge the general market sentiment. On a down day, almost all companies decline, and on an up day, almost all rise. As I understand it, this is due to the impact of heavily diversified index funds. Money flows in and out of them, which fluctuates all stock prices. When it’s said that the stock market is expensive, this often refers precisely to the expensiveness of the index.
However, I’ve noticed that company valuations don’t always depend on the index. For example, the last time Orion B was 24 euros in April 2014, the OMX Helsinki PI was at 7500 points (now 10200). Nordea’s stock cost 8.2 euros last in June 2016 when the index was below 8000 points. So, is it possible that the index is expensive only due to the overvaluation of some companies? Recently, I’ve been thinking about the strongly rising engineering and forest industry companies. In hindsight, Stora Enso’s book value per share is approaching 8 euros, which was the share price a couple of years ago.
The index value is determined by the weighted averages of the market values of the shares. For example, the following shows an index with three companies with the following market values and price developments:
100MEUR -0.24%
30MEUR +0.55%
20MEUR +0.30%
The index for these companies would then be -0.01% = (-0.24%*100 + 0.55%*30 + 0.3%*20) / 150.
Is the index’s point value simply 150?
What should one think about these indices? It feels like if one invests in a reasonably priced company at the peak of a cycle, it will still fall with the others when an expensive index collapses, and the expected value of the investment is equally negative. Should one wait for a crash first and then pick the good companies for the portfolio?
The index value can be anything. It’s not essential. We could now decide that OMX PI is 100, and it wouldn’t have any impact in any direction. Only direct comparison to the past would not be possible. The index value only describes change, and the absolute value of the index itself has no significance.
In your example situation, you can determine the weighting of companies in the index: 100/150, 30/150, and 20/150. The index value can be chosen as anything, for example, 1, 100, 150, or 10,000. However, after the index is established, it’s not sensible to change the scoring to make comparisons to the past meaningful.
Theoretically, it would make sense to always buy when stock prices generally fall, but you can never know if they will go lower than they are now. For example, in Venezuela, stock prices have risen several thousand percent over the year, so the index is unlikely to ever drop to last year’s level. The situation in Venezuela is, of course, exceptional, but it is possible.
Therefore, it’s not sensible to wait for better buying opportunities but rather to buy reasonably priced companies when they come along. In an expensive market situation, one can, of course, increase the cash balance and reduce purchases, but it’s quite dangerous to just wait for a better time. Waiting would have meant missing out on significant gains in the last 10 years.
In your message, you refer to companies’ growing profits, which rise with inflation. The P/E ratio has the clever advantage of accounting for inflation. It asks how much the market is willing to pay for a company’s earned euro, regardless of the euro’s purchasing power. Currently, the earnings yield (E/P) of the US S&P 500 index is a mere 4% and the dividend yield is a laughable 1.84%. Since stocks are risky investments, the return should be much higher – the historical median is 6.81%. Either S&P 500 companies’ earnings should grow by 69% or the index should collapse by 41% to reach the historical median. Also, the Shiller P/E ratio for the S&P 500 index is double its historical median. It thus seems clear that the index will crash. This has happened before. Crashes have momentarily caused a strong drop in demand in the real economy, which has been reflected in the earnings of the index’s companies.
The valuation level is strongly influenced by the interest rate level, so in comparison, the index is not as expensive as what its P/E ratio suggests. A lot depends on how interest rates develop from here.
The stock market is certainly expensive in my opinion now, but there are no guarantees of a crash. The ascent could continue forever.
Nordea’s move to Finland will reset the weighting of the OMXH25 index, for example, after the turn of the year. Is there a risk that a market disruption of some kind could occur, for example, when index funds adjust their portfolios to match the changed index?
