Market history has shown that there is a positive relationship between investor sentiment and stock market returns.
Stock prices tend to go up and generate excess returns when market sentiment is optimistic, but when investors are uncertain about the future, stock prices tend to weaken and fall, resulting in losses.
We have seen how market optimism has driven stock prices to recover over the past 12 months, because of expectations of a strong recovery this year.
The average premium being paid by investors on stocks has been increasing since the pandemic started, from a low of -18 percent during the height of the crisis to 38.5 percent last year.
Today, with the economy returning to normalcy, the average market premium has increased further to 40.3 percent, indicating investors’ positive outlook so far this year.
By historical reference, the current market premium is almost back to its prepandemic levels, which averaged about 41 percent during the bull market of 2014 to 2018.
But in a market environment where there is a constant threat of rising inflation due to the surging global prices of oil and commodities, not to mention a falling peso, paying a premium for a stock’s earnings recovery may be too risky.
In fact, an increase in market premium along with a rise in inflation and interest rate risks is indicative of a stock market bubble.
Remember that the price of a stock consists of an intrinsic value and a growth premium.
The intrinsic value, which represents the present value of a stock’s future earnings, is partly determined by the movement of interest rates in the market.
An increase in interest rates can make stocks overvalued by lowering its intrinsic value and inflating its growth premium.
For example, if we want to compute the intrinsic value of AC Energy, we can simply discount its 12-month trailing earnings per share of P0.12 by its opportunity cost of 9.2 percent to derive a value at P1.30 per share.
To estimate the premium of the stock, we can simply deduct the intrinsic value of P1.30 per share from its share price of P7.88 to derive a growth premium of P6.58 per share or 83.5 percent of its market value.
Now, let’s assume that interest rates will continue to go up. If the interest rate increases by 1 percent, the opportunity cost of the stock will also increase by 1 percent to 10.2 percent.
The increase of 1 percent in the stock’s opportunity cost will lower its intrinsic value by 10 percent from P1.30 per share to P1.17 per share.
Because the intrinsic value is lower, the growth premium portion in the stock price will be larger.
In this case, the decline in the intrinsic value of AC Energy will inflate the already bloated growth premium of the stock from 83.5 percent to 85.1 percent, which could burst anytime in a correction.
If we apply the same framework to the overall stock market, how low can we expect the Philippine Stock Exchange (PSE) index to fall?
If the current market premium is 40.3 percent and the level of PSE index is 7,112, we can derive its implied intrinsic value at 4,248 by removing the premium.
If interest rates continue to shoot up in the coming days and the 10-year Philippine bond yield, which has been increasing from 5.27 percent to 5.67 percent, continues to increase to 6 percent, the intrinsic value of PSE index could shrink to 4,113.
A lower intrinsic value of 4,113 against PSE index of 7,112 will result to a higher market premium of 42.2 percent, which makes stock prices overvalued.
In theory, in order to restore the premium at 40.3 percent, the PSE index will have to fall to 6,889 level, but in reality, when uncertainties begin to worry investors, the average premium may also decline.
If market premium regresses to last year’s average at 32.5 percent with interest rate rising to 6 percent, the PSE index could fall to as low as 6,093 level. 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 info@rfp.ph or text at 0917-6248110