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How do pandemic sentiments affect stock prices?

/ 04:01 AM May 13, 2020

In the late 1960s, a professor from University of Chicago by the name of Eugene Fama developed a theory called the efficient market hypothesis.

According to this theory, stock prices, in general, incorporate fully all relevant information at any given time in a liquid market. It argues that since the market is efficient, there are no stocks that can become undervalued or overvalued.Because share prices will always indicate the correct valuations, Fama contends there are very limited opportunities to outperform the market.

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But by experience, we know that the markets are not efficient because feelings and sentiments can also influence stock prices.

Not all investors are rational decision makers. There are also investors who invest based on their beliefs or emotions.

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Past studies have shown that investors tend to shrug off negative reports when the market is strong, but when the market is weak, investors tend to magnify every small piece of bad news.

This happens because when market psychology is positive, optimistic investors assume more risks by paying stocks at higher prices, but when sentiments turn negative, investors also become pessimistic and sensitive to risks.

In other words, because emotions can influence investment strategies, stock prices cannot reflect fully its real values. Human psychology will always have significant effect on market behavior.

During this time of crisis, it is not hard to imagine that many people are anxious and maybe even depressed over how this coronavirus lockdown is going to last.

The longer this lockdown goes on, the more pessimistic people get. This negative mood can influence how investors feel about the market in the future.

We recall that the price of a stock represents the present value of its future earnings that come from two sources, one from its existing assets and the other from its growth opportunities.

If the market is optimistic about the growth potential of a stock, it will pay a premium over the value of its earning assets, but if it is having negative outlook, it will pay nothing or may even demand a discount.

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For example, at the start of this year, the value of Robinsons Land’s earning assets as defined by its cost of equity was P19 per share. By deducting this from its stock price of P27.5 at that time, we can infer that its premium was P8.4, or 30.5 percent premium.

This premium reflects how optimistic the market was about the growth of the stock until the coronavirus outbreak came and wiped out everything. Today, Robinsons Land is trading at a discount of 2.2 percent.

Over at the Philippine Stock Exchange (PSE), we have observed that the median premium of index stocks has been declining since 2017 from 47 percent to 42 percent in 2018 due to the rise of interest rates.

But by the end of 2019, despite falling interest rates, market premium of growth opportunities fell significantly to 21 percent. We can see that at this point, the market was already anxious as if something terrible was about to happen in 2020.

So, in less than three months, at the onset of the crisis when the market crashed to its historic lows, sentiments turned from anxiety to panic. The small premium of the market quickly disappeared when the perceived value of growth opportunities fell to a negative 18 percent.

One would assume that market sentiments should have somehow improved after the PSE index has recovered by 21 percent from its recent lows and the further decline in interest rates.

But as expected, with all these anxieties about possible lockdown extension, market pessimism remains high. In fact, the growth discount even increased to 20 percent.

In a challenging environment like this where a pessimistic market will always expect share prices to trend lower, buying stocks based on fundamental data is not enough.

One also must consider sentiments that lead to changes in prices. INQ

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities. To learn more about investment planning, attend the 82nd batch of RFP program live online this May 2020. To register, email [email protected] or text at 0917-9689774.

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