Should you worry about a stock market crash?

It is good to know that the economy is slowly returning to normal as the era of pandemic restrictions is quickly coming to an end.

Over the past 12 months, we have seen how the stock market has recovered strongly, despite the unrelenting rise in COVID-19 cases.

The market’s appetite for risk has notably been increasing with investors tolerating higher stock prices in the hope of a strong economic recovery this year.

If we look at the trend of the risk level in the market, we can see that the implied risk premium has been falling consistently over the course of the crisis, from 12.5 percent during the height of the COVID-19 outbreak in 2020 to 7.2 percent last year.

Today, the implied risk premium is even lower at 6.6 percent, indicating rising market optimism, and with the health crisis fading faster than we think, it is possible that the risk premium could fall further.

A lower risk premium, assuming interest rates remain at current level, means higher market valuation, which should justify higher stock prices.

For example, if we expect the implied risk premium to fall further to 6 percent, this would mean that the market should trade at a price-to-earnings (PE) ratio of 18.9 times from the current 17 times PE.

At this target market PE, the current Philippine Stock Exchange (PSE) index should rise by at least 11 percent to the 8,200 level.

But a low-risk premium market could also mean that the share prices are relatively overbought, with declining rates of expected returns.

Risk of rising inflation triggered by postpandemic recovery could result to higher interest rate that could easily make the current market overvalued.

An increase in interest rates would make the market’s rate of expected return go up, too, which would prompt investors to bargain for lower share prices.

The 10-year Philippine bond yield has been increasing since the start of the year from 4.72 percent to 5.27 percent today, the highest in three years.

If we expect the 10-year bond yield to go up further to 6 percent in the coming weeks, assuming the same implied risk premium of 6.6 percent, we would get an intrinsic PE ratio of 15.2 times for the market.

At this revised PE valuation, the PSE index could fall to 6,500 level.

Now, the other way to understand this concept is by looking at its earnings yield.

If we get the inverse of the market’s current PE ratio of 17 times, we will derive an earnings yield of 5.9 percent.

By comparing this yield against the prevailing 10-year bond yield of 5.27 percent, we can compute the excess return of stocks over bonds at 0.63 percent.

In theory, the excess return indicates that there is still upside left for the market.

If we make the earnings yield equal to the prevailing bond yield of 5.27 percent, it would mean that the market’s PE ratio could still go up to 18.9 times.

This is good if we are expecting interest rates to fall, but because of the expected rise in inflation, not to mention the rising global prices of oil and commodities brought about by the ongoing Russia-Ukraine war, there is a very good chance that interest rates will continue to go up.

If we assume the 10-year bond yield to go up to 6 percent, the excess of the market’s earnings yield over bonds will be reduced to negative 0.1 percent, which will make stocks overvalued.

In order for the market to restore its equilibrium at 0.63 percent excess return, given a bond yield at 6 percent, earnings yield will have to increase to 6.63 percent.

This target earnings yield will happen if the market’s PE falls to 15 times, which give us the same PSE index target of 6,500 level.

Of course, the market could fall lower than 6,500 if interest rates rise way over 6 percent in the coming weeks.

Just as things are beginning to look up, a large “wall of worry” is gradually emerging in the horizon. Inflation and interest rates are the key factors to watch out for as they start to unsettle the stock market. 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 94th batch of RFP program this March 2022. To register, email [email protected] or text at 0917-6248110