Are you ready for the next stock market crash?

Question: The stock market has been quite volatile lately and I am not sure if this is the time for me to accumulate while the market appears to be consolidating or an opportunity to take profits while stock prices still look strong. What should I do? —Mhelay Sweetlove by e-mail

Answer: Several weeks ago, I wrote in this column “Should You Buy High and Sell Higher?” that strong stocks can get stronger only when they are nearing their historical 52-week high. This was because the strong momentum that pushed the market to break out in January was on track to reaching our initial target of 7,860.

On Feb. 25, several index stocks closed stronger when the market finally achieved this target and hit 7,862. Since then, the market has been trying to fight off profit taking pressures by attempting to get past this level, which has now become a strong resistance. While the market struggles to stay on top with momentum slowing down, the risk of imminent fall also increases. Does this mean the market is going to crash soon?

Given the benign fundamental backdrop of the economy, a market crash of 300 point loss in one day is unlikely but not impossible. What is more probable is that the market may eventually succumb to a massive correction if it continues to fail in breaking the 7,860 level. A major correction, if it happens, will cause the market to fall by as much as 600 points to 7250 over several weeks, or even months.

If the market recovers and breaks out of 7,860, the likely next target will be 8,000. At this point, if you held on to your shares and wait for the market to go up further; you would have gained an extra profit of 1.8 percent. However, if the market reverses and falls, you may lose by as much as 7.6 percent. As the market gets higher, the incentives get smaller and the risk of losing big gets bigger.

The chances of market correction are high given the current valuation of the market. At the 21x P/E, the Philippines is now the most expensive stock market in the region. Further rise may be limited as all good things about the economic growth story must have already been priced into the market.

In fact, share prices may have gotten too far ahead of the fundamentals. The total market capitalization right now is already about 101 percent of the gross domestic product (GDP). Normally, the ratio must be between 75 percent and 90 percent for the market to be considered fairly valued. In this case, the market is now modestly overvalued.

For the market to justify its current valuation, the GDP must grow by 10 percent this year to bring down the ratio to 90 percent, which may not be easy. Because the long-term growth of corporate profitability is tied to long-term growth of the economy, the market, sooner or later, should eventually correct to acceptable levels. In order for the market cap to become 90 percent or less of GDP, share prices must fall by 10 percent or more.

Moreover, the implied earnings yield of the market, derived by reversing the P/E, is already at 4.8 percent. A 10-year government bond has an average rate of only 4 percent. The difference of 0.8 percent is the risk premium which investors normally demand as extra return for investing in riskier investments like stocks compared to risk-free government bonds.

If the market continues to go up with higher P/E, the implied earnings yield will fall and risk premium will be lower, giving investors very limited incentive to make money from stocks. Imagine if the market goes up further to 25x P/E, the implied earnings yield will fall to 4 percent just equal to risk-free government bonds with zero risk premium. So why will investors risk their money if they can get the same return from government bonds that offers no risk of losing?

While you can still sell your shares at a good price, there is no reason why you should not prepare for the worst. Start changing your strategy to defensive mode from offensive. Build your cash during the good times so you have enough reserves to invest when the bad times come. Raise cash by getting rid of highly volatile stocks through taking profits or cutting your losses. Ideally, the best time to get out is when losses are still at 10 percent or less because you can always recover it next time.

Limit your holdings by focusing on stocks that are less sensitive to market volatility. You can identify the stock’s historical volatility by looking at its beta. The lower the beta, the lower the volatility, hence lower risk of damage when the market falls.

Not all low beta stocks are good so find the ones that have solid fundamentals. By experience, choose the stocks that give out cash dividends regularly because these are the ones that will endure and survive. Although low beta stocks are normally boring because they do not provide enough excitement, they are reliable and stable in times of high market volatility.

Some of the dividend paying stocks, which has beta of less than 1.0, that you can consider buying when the market falls are PLDT (0.74), Aboitiz Equity Ventures (0.54), Aboitiz Power (0.52), Globe Telecoms (0.58) and Manila Water (0.70).

A falling stock market offers great opportunities to buy stocks at lower prices. When this happens, try to keep your perspective at hand and take advantage of the situation. Do not panic. Be prepared to buy the stocks you want at the right prices and always protect your portfolio.

Henry Ong is a registered financial planner of RFP Philippines. Learn more about investing at the 3rd Financial Fitness Forum on March 28 at SMX Aura. To inquire, e-mail at [email protected] or text <name><email><FFF> at 0917-3464126.