Is the stock market poised for a big breakout soon?
If the market is anticipating higher growth and lower risks to drive returns this year, the current share price consolidation should offer a good opportunity to buy stocks now.
Earnings of the 30 companies belonging to the PSE index grew by a median of 12.6 percent last year, more than double the 6 percent earnings growth in 2017.
With the economy expected to remain robust this year amid falling inflation and interest rates, it is not hard to assume that earnings will continue to grow.
Such growth expectations, however, have yet to be fully reflected in the share prices.
Remember that the value of a stock has two parts. One is the value of the “assets in place” and the other is the value of growth opportunities.
If the market does not expect the earnings of a stock to grow significantly in the near future, its share price may simply trade at the value of its assets.
But if a stock is perceived to have great potential, the market will pay a premium for its growth.
In the same period last year, the share of growth expectations in the value of stocks in the market was about 40 percent.
At some point during the year when the market was overvalued by the increase in interest rates, the share of growth value went up to as high as 48 percent.
This year, the share of growth value in stock prices is only 35 percent despite the recovery in the market.
If we are going to translate this into an annual growth basis at current prices, the market appears to be expecting earnings to grow only by an implied rate of 9 percent.
The implied growth rate is derived by taking the internal rate of return between the value of “assets in place” of a stock and its current market price over a five-year period horizon.
In other words, if the market expects earnings to grow higher than 12.6 percent this year, share prices must increase considerably on account of the higher value of growth opportunities.
In my column last January entitled “Will the stock market hit an all-time high this year?”, I also explained that if interest rates continue to fall to 6 percent, then the opportunity cost to invest in stocks should also fall.
This opportunity cost, which is computed by getting the sum of the “risk free” interest rate and risk premium, is the minimum return that investors will typically expect from investing in stocks.
At a lower interest rate of 6 percent as represented by the 10-year Philippine bond yield, the opportunity cost was estimated to decline to 10.6 percent.
Lower opportunity costs mean lower risk, which increases prospective market valuation.
At a minimum return of 10.6 percent and long-term growth rate of 6 percent equivalent to our GDP growth, the fair value of the market was estimated at a price-to-earnings (P/E) ratio of 22 times.
Again, the market has yet to realize its full potential as its current P/E multiple has remained unchanged at 16 times despite lower opportunity cost today at 10 percent brought about by lower interest rates.
The 10-year Philippine bond yield has been falling since the start of the year to as low as 5.6 percent.
The earnings yield of the market, which is simply the reverse of the current P/E ratio, is already way above the 10-year bond yield at 6.4 percent.
A rising earnings yield obviously makes investing in stocks more attractive than investing in fixed income securities.
But investors seem to be hesitant on where to go next despite compelling market fundamentals.
The current market indecision should be a good time to accumulate promising stocks, align portfolio allocation and prepare for the next big move.
There is a saying that good fortune often happens when opportunity meets with preparation.
While it is normal to expect share prices to continue their uptrend, especially after a healthy price movement, from a long period of market consolidation, there is always the risk that the trend may reverse.
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