Understanding and using the STI

Newspaper typically mention stock-market indices when recounting dramatic events shaking the financial world. Black Monday, or Oct 19, 1987, is one such example. The Wall Street Journal reported the next day: "The stock market crashed yesterday. The Dow Jones Industrial Average plummeted an astonishing 508 points, or 22.6 per cent, to 1738.74."

Over in Singapore, a front-page Straits Times article on Oct 21, 1987, noted that the Singapore stock market "suffered its worst single-day plunge of 261.78 points". It said: "The plunge beat Monday's record fall of 169.14 points and the market finished at 961.50, the lowest level since Jan 28."

Now, the Straits Times Index (STI) is used as a benchmark for the Singapore stock market. It closed at 3269.31 points last Friday. It is a household name that has come a long way from its beginnings as an industrials index compiled by The Straits Times in 1958, which became the Straits Times Industrial Index in 1966 before it was revamped to become the STI in 1998.

But what do the numbers on the STI mean? What is it used for, and why? What exactly is in it?

More importantly, how can an investor use it to make money?

A basket by any other name. . .

The STI was created by Singapore Press Holdings (SPH) and is managed by SPH, Singapore Exchange and FTSE Group.

Some 30 stocks make up the index. They represent the most liquid stocks with the largest market value in Singapore, across various sectors. This makes the index reasonably well diversified and an accurate reflection of changes in market value in Singapore stocks across all sectors.

The index is value-weighted. If the price of a component stock changes and causes the overall market value of the 30 stocks to go up by one per cent, the index will go up by one per cent.

Investors can use the STI in three ways.

Firstly, the STI is used to gauge the mood of the Singapore stock market.

If the STI hits a five-year low, investors can read this as a lack of confidence in the market about companies' prospects, such that the last time confidence was so low was five years ago. This could arise due to a global economic downturn given the open nature of Singapore's economy.

A contrarian investor might decide that the market cannot fall much further. Other valuation ratios such as price-to-earnings ratios and price-to-book ratios can be used to find cheap but fundamentally sound stocks to buy.

If the STI hits a five-year high, it means that the market is at its most optimistic, in the last five years, about the earnings of companies increasing more in the future. It thus prices companies at a higher market valuation. Again, this might be a signal for an investor to take some profit.

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