Is the worst over for the stock market?

It has been said that when times are uncertain, investors tend to become more defensive and sensitive to risk, as they magnify every piece of bad news in the market.

But when times are good, investors tend to ignore negative concerns that might otherwise cause stock prices to fall, because they become more optimistic and risk tolerant.

Over the past two months, we have seen how the stock market recovered strongly despite the unrelenting rise in COVID-19 cases.

It was not a very good time to be positive as the health crisis continued to worsen, but investors chose to look beyond the economic worries.

Collective social mood theory suggests that an optimistic stock market could mean better times ahead for the economy.

With lockdowns getting less restrictive and mobility increasing, investors are taking more risks in the hope of higher returns in the future, as the economy slowly recovers.

If we observe the level of risk in the market, we can see that the market’s appetite for risk has been increasing as the implied risk premium declines.

Lower risk premium

The risk premium, which is the extra return that investors would normally demand to compensate for their risks in the stock market, has been falling significantly from 9.75 percent last year to 7.2 percent this year.

A lower risk premium means investors are more risk tolerant because they are willing to settle for a lower extra return.

If we compare this to last year, during the height of the coronavirus pandemic, worried investors demanded higher extra return, which increased the implied risk premium to as high as 12.5 percent.

The high-risk premium did not only show how risk averse the market was, but also how undervalued the stock prices were.

Today, despite the recent resurgence in COVID-19 cases, the risk premium in the market continues to go down, indicating that investors are now less anxious and more confident that this crisis will be contained at some point in the near future.

A low-risk premium also means that high stock prices may be relatively overbought, as the stock market attempts to surmount the current challenges of the pandemic.

By reference, if we look at the historical risk levels of the market, the lowest risk premium was 4.2 percent, which was achieved when the Philippine Stock Exchange (PSE) Index topped out in January 2018.

Rising interest rates

Using this as basis, at current risk premium of 7.2 percent, we can safely say the market still has plenty of space for risk tolerance.

So, even if we assume the market to go up to the same price-to-earnings (PE) ratio in 2018 at 20.4 times, which is roughly equivalent to PSE Index of 8,500 level, the implied risk premium will just hover around at 6.2 percent.

But there is one fundamental concern that may limit the further recovery of the market: the rise in interest rates.

The 10-year bond yield, which has been increasing along with the rise in the stock market for the past two months, has escalated from 3.88 percent in July to a high of 4.72 percent this week.

An increase in interest rate in a low-risk premium environment makes the stock market overvalued because investors will seek lower stock prices to compensate for their higher opportunity cost.

For example, the average earnings yield today in the market at 16.7 PE ratio is 5.8 percent. If we compare this against the 10-year bond yield of 4.7 percent, we will derive an excess of 1.1 percent.

But if interest rate will continue to go up because of rising inflation outlook to, let’s say, 6 percent, the excess of earnings yield over interest rate will be cut to negative 0.2 percent.

Under this scenario, share prices will have to fall so that the earnings yield can catch up with interest rate. In order to restore the equilibrium at 1.1 percent excess return, earnings yield will need to rise to 7.1 percent.

If this happens, higher earnings yield will mean lower PE ratio of 14.1, or a potential decline in the PSE Index of 15 percent.

While the market may have climbed a large “wall of worry” recently, rising interest rates and inflation are slowly emerging to be the next proverbial wall for the market to climb. INQ