How to stay ahead of market uncertainty
In these unprecedented times, the global economy is facing a looming recession and an increasing uncertainty that is impacting the stock market.
One critical indicator that investors can use to gauge market sentiment is the implied risk premium.
The implied risk premium is the difference between the expected return on a risky investment, such as a stock and the risk-free rate, such as a government bond.
This premium reflects the perception of current market risks and represents the extra returns investors demand to invest. The higher the perceived risks, the greater the implied risk premium.
Changes in implied risk premium can signal changes in the market’s expectations and can impact stock prices. For example, when uncertainty increases due to factors such as interest rates, inflation or geopolitical risks, the implied risk premium also rises.
This leads to investors demanding for higher returns, resulting in lower stock prices, as the future cash flows from the stocks are discounted at a higher rate.
If we examine the trend of the market’s risk level, the implied risk premium has consistently declined from its peak of 12.5 percent during the height of the pandemic to 6.6 percent in May of last year.
However, the increase in interest and inflation rates last year created uncertainty in market sentiment, causing the implied risk premium to rise to 8.3 percent by year-end.
Today, the implied risk premium is 8.7 percent, indicating a growing sense of pessimism in the market. If we apply this risk premium to equity investments, the minimum required rate of return that investors will demand will be 14.7 percent. This is derived by adding the implied equity risk premium of 8.7 percent to the prevailing 10-year bond yield of 6 percent
Given the minimum required rate of return of 14.7 percent, we can compare it to the current earnings yield of the stock market. The median price-to-earnings (P/E) ratio of the Philippine Stock Exchange index (PSEi) is currently at 12.6 times. To calculate the market’s earnings yield, we can simply invert the P/E ratio to a percentage, which gives us a yield of 7.9 percent.
Considering that investors are expecting to earn 14.7 percent against the current yield of 7.9 percent, it is reasonable to assume that stock prices will need to decline in order to adjust to the higher yield.
If we anticipate the market’s earnings yield to increase to its prepandemic average rate of return of 12 percent, then the PSEi would theoretically have to eventually decline to a level of 4,366.
However, with inflation beginning to decrease recently, a drop in interest rates could help to prolong the market’s stability, as a decrease in the minimum required rate of return supports a lower earnings yield.
Nevertheless, the ongoing global crisis has yet to be resolved, and there is a possibility that the risk premium could rise further, especially if interest and inflation rates continue to remain elevated.
To minimize risk and preserve capital in the coming global recession, we should adopt defensive investment strategies. One such strategy is the dividend investing, which focuses on investing in companies that pay regular dividends.
Dividend-paying companies are usually mature and stable companies with a consistent track record of profitability. In a recession, these companies are likely to be more resilient and able to maintain their dividend payments. Examples of companies with attractive dividend yields include Globe Telecom (5.8 percent), Synergy Grid (6.8 percent), Semirara Mining & Power Corp. (24.6 percent) and GMA Network (11.1 percent).
Another is to invest in quality companies with a strong balance sheet, consistent earnings growth, and a competitive advantage at historically low P/E multiples. Some of these companies are SM Prime Holdings, Meralco and Puregold.
For those who prefer to reduce their exposure to the stock market, investing in bonds issued by companies with a good credit standing is an option. These bonds typically offer relatively high interest rates as a way to compensate for the lower risk compared to stocks.
In general, companies with predictable earnings growth are perceived to have lower risk, which may lead to a lower equity risk premium for these companies.
It is important to keep in mind the long-term perspective and not get caught up in short-term market fluctuations.
Historically, the stock market has always recovered from downturns and gone on to achieve new highs. Therefore, it’s important to stay invested and not panic during a market downturn. 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 101st batch of RFP program this May 2023. To register, email email@example.com or text at .0917-6248110
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