Is the stock market going to crash again in 2021?

What started out as a recovery story, driven by strong market optimism, is slowly turning into a prolonged relapse, as share prices fail anew on rising anxiety and pessimism.

The resurgence of coronavirus cases to all-time high levels, the reimposition of lockdowns and the recent surge in inflation seemed to have crushed any hopes of revival in consumer confidence this year.

When market outlook is less positive, as uncertainties increase, we can expect market risk premium to also go up, as investors seek extra returns to cover their risks from buying stocks.

But, today, if we are going to compute for the implied risk premium of the market, we will find that it is actually lower at 8.1 percent from 8.7 percent at the start of the year.

This is because a portion of the risk was already reflected in the rise in interest rate, which has been increasing since January due to higher inflation.

The 10-year bond yield has increased from 2.98 percent to a high of 4.67 percent in March, as inflation accelerated to 4.7 percent in February from a low of 2.3 percent in October last year.

Without the rise in interest rate, the implied risk premium would have risen to 9.3 percent from 8.7 percent.

But, just the same, even with lower risk premium, higher interest rate increased total required rate of return to 12.4 percent from 11.8 percent in January.

A higher required rate of return lowers the present value of a company’s future cash flows, which result in lower stock price valuations.

Early this year, we also discussed in this column “Is the stock market poised for a bull run this 2021?” that the high excess return of the market’s earnings yield over interest rate was making equity investment attractive.

We compared the market’s earnings yield in January, which was 5.8 percent, against the prevailing 10-year bond yield at that time of 3.05 percent, and generated an excess return of 2.71 percent.

Today, if we will take the inverse of the current market Price-to-Earnings (PE) ratio of 14.2 times, we will find that the market’s earnings yield actually increased to 6.4 percent.

However, because the 10-year bond yield has also increased to 4.36 from 3.05 percent, the excess return declined to 2.06 percent from 2.71 percent, which reflect the dominant negative sentiment in the market.

Such negativity has also turned the market to be more pessimistic about growth in the near future.

We know that investors pay more for stocks when they are optimistic about its growth prospects, but when they are anxious, they bargain for less and pay lower prices.

We have discussed in the past that we can measure the premium the market is paying about a stock’s growth opportunities by simply deducting the value of its earning assets from its market price.

Based on this, we estimated that the average premium of the market in January has recovered from a discount of 20 percent last year to a premium of 27.2 percent.

But today, with the resurgence of COVID-19 cases and the rise of bond yields, the average premium has fallen to only 2.4 percent at current market prices.

Although average premium remains positive despite the fall in stock prices, there are risks that prolonged lockdowns and continuous rise in cases can drag the market’s growth recovery.

If we remove the premium from the market by turning it to zero, we can simply deduct 2.4 percent from the Philippine Stock Exchange index (PSEi) last Monday to derive a target of 6,341.

If we are more pessimistic, assuming inflation and bond yields remain high, we can assume a conservative discount of 5 percent, which could bring the market to a low of 6,170.

A more aggressive discount, on the other hand, let’s say at 10 percent, can bring the PSEi to 5,845.

While it looks like the pandemic is going to get worse before it gets better, we should remember that, as history has shown, there are always opportunities to create value.

Let us use this crisis to reposition our investments and prepare for recovery when we finally get back to normalcy. 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 89th batch of RFP program this May 2021. To register, email [email protected] or text at 09179689774.