Why I don’t think the stock market rally is sustainable

The stock market has been very strong lately, rising by a total of 969 points or 17.6 percent in the past eight trading days to close at 6,465.13 last Friday.

The market’s strong performance was fueled by numerous factors. First, there is optimism that the worst is over as the Philippine economy is slowly reopening after several months of lockdown. Although there is still a lot of bad news, the market is forward looking which means it is more focused on the brighter future rather than the bleak past.

Next, the US dollar is weakening against the peso and most global currencies. Note that the dollar index has fallen by about 3 percent the past two weeks. In fact, the dollar is now back to where it was during the start of the year after appreciating by as much as 7 percent in mid-March because of the flight to safety during the height of the COVID-19 pandemic.

The weaker dollar is a strong indicator that risk appetites have returned. Because of this, foreign fund managers are flocking back to riskier emerging market stocks that were severely battered during the past few months. Note that the MSCI Emerging Market Index has gone up by a total of 10 percent since May 26, when the PSEi began to rally.

While I am happy that the Philippine stock market is performing strongly, I am still not convinced that the rally is sustainable.

Although I agree that the worst is over, I have not changed my view that the Philippine economy will go through a “U” and not a “V” shaped recovery. In fact, recent developments further strengthen my view that the economy will go through a slow recovery. For example, last Friday, the government announced that the unemployment rate jumped to a record high of 17.7 percent in April. Although this number will most likely improve in the next few months as businesses reopen, I am 100 percent sure it won’t return to its April 2019 level of 5.1 percent given the store closures and layoffs announced by the likes of Jollibee, BPI and Victoria Court.

Moreover, valuations today are already expensive. When I first wrote about why I was cautious about the stock market’s rally a few weeks ago, the PSEi was still at 5,500. At that level, I said the stock market was cheap compared to its historical average but still had room to go down based on past bear market bottoms. However, at 6,500, the PSEi is already expensive as it is trading at 17.6X 2020 P/E, which is a premium to its 10-year historical average P/E of 17.3X.

If you don’t think property developers can justify increasing the prices of their properties for sale because of the COVID-19 pandemic, then you should understand why I don’t think stocks can justify trading at above average valuations.

And while it is true that 2021 will be better than 2020, I don’t think economic activity in 2021 will be back to 2019 levels. Unless we find a vaccine or a treatment for COVID-19 within the year, consumers will remain cautious while rules encouraging social distancing will still be in place. Although our government is rolling out a fiscal stimulus program, it is small and spread over several years. Because of this, I think consensus earnings forecast for the PSEi which assumes that 2021 profits will be back to 2019 level will slowly be revised lower. With risk still on the downside, it is hard to justify paying above average valuations for stocks even though the stock market is forward looking.

Because of the said reasons, there is a strong chance that the stock market rally will not be sustained. As such, investors who own stocks today should consider taking advantage of the market’s rally to lighten up and wait for more attractive levels to buy back stocks.