Is the stock market poised for a bull run this 2021?

There is no doubt that 2020 was the most challenging year for the stock market. It was a period of uncertainties characterized by losing businesses, rising unemployment and a declining economy.

But this year, with the economy returning slowly to normalcy, the prospects are looking better. We now have a clearer direction for the future even though many businesses are still struggling to survive.

The coming of the vaccines and the gradual restoration of consumer confidence have resulted in greater certainty, which makes business more predictable.

And when market outlook is less negative, the risk premium is lower, which helps increase share price valuations.

Last year, during the outbreak of the coronavirus, when the government announced a mandatory lockdown, the stock market crashed to its lowest level in 10 years.

At that time, the equity risk premium, as implied by the fall in stock prices, accelerated to a high of 12.5 percent from only 8.6 percent at start of the year, due to heightened uncertainty.

Although the market quickly recovered in the weeks that followed, especially after the Central Bank cut key interest rates, the implied risk premium has hardly changed at 12.4 percent, signifying extreme market anxiety.

This situation only improved sometime in June when the government started relaxing the quarantine protocols. The implied risk premium fell to 11.6 percent for the first time since the start of the pandemic, which drove the stock market to rally.

By October, the implied risk premium improved further to 9.75 percent as COVID-19 vaccines became available in the United States and other countries.

Seeing light at the end of the tunnel, the resulting lower risk premium helped the stock market to advance and lower its losses to only 8.6 percent by end of 2020.

Today, the implied risk premium of the market stands at 8.7 percent, which is almost the same level from where we started in 2020 before the outbreak of the pandemic.

The market may look expensive at current level as the Philippine Stock Exchange index (PSEi) nears a historical resistance at 7,500, but if we look at the earnings yield of the market, which is the inverse of the median Price-to-Earnings (PE) ratio of 17.4 times, it is still very cheap at 5.8 percent.

At this return against the prevailing 10-year Philippine bond yield of 3.05 percent, the excess of 2.71 percent still makes the Philippine stock market very attractive.

The PE ratio that we used in this analysis was based on a 12-month trailing earnings, which accounted only the actual nine-month earnings of 2020 and the last quarter of 2019.

Now, if we annualize the nine-month earnings to get full year estimate for 2020, we will find that the total earnings last year by PSEi stocks would fall by 52 percent compared to 2019 level.

Using the earnings estimate to price the market, we will get a PE ratio of 21.9 times, which may be historically high, but if we convert this ratio into an earnings yield, the market will still come out reasonable at 4.6 percent, which is way above current interest rate.

Perhaps, this expected increase in PE valuation will provide investors the excuse to take profits, which should give the market its much needed correction.

But, remember, the stock market is always forward looking. With the economy coming off a low base this year, we can also expect corporate earnings to recover strongly.

If we divide the current PSEi of 7,203 by its market PE of 17.4 times, we will get a composite earnings base of 415.

Assuming earnings will grow only by 15 percent this year and we apply the same PE ratio of 17.4 times, we will derive a target for the PSEi to achieve before year end at 8,283.

But, let’s say, we are more optimistic and we expect earnings to grow higher at 25 percent, then the PSEi should reach at least 9,003 level this year.

As we emerge from the crisis, the implied equity risk premium should fall further as confidence returns. Hopefully, the year 2021 will be the beginning of our journey to sustained recovery. 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 87th batch of RFP Program this January 2021.

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