Where does the market go from here?

It has been over a month since the Philippine Stock Exchange index (PSEi) suffered its worst meltdown in history, losing over 700 points in a single day due to the coronavirus pandemic.

While the market has recovered by as much a 47 percent since then, albeit on low volume turnover, there seems to be no clear signs yet on how this crisis will be resolved.

And the longer this quarantine period is extended, the greater the uncertainty in the market. When uncertainty increases, risk premium also increases, which leads to lower share price valuations.

For example, when the market panicked over the coronavirus outbreak last month, the equity risk premium as implied by stock prices accelerated to 12.5 percent from 8.6 percent at the beginning of the year.

The sudden increase in premium, which led the market to crash to its record lows, was historically high considering that it would normally average between 6 and 7 percent in a good and stable market.

Once the market started to recover slowly the following day, one would expect that such high premium will also correct, especially after the central bank announced that it would cut interest rates further.

But much to our surprise, despite the significant recovery in share prices, the implied risk premium has hardly changed to this day at 12.4 percent.

This high equity risk premium suggests that the worst is far from over. Rising uncertainties from the economic effects of the lockdown will continue to hound the stock market in the coming months ahead.

There are two key drivers that will impact the future value of the market. One is earnings growth and the other is opportunity cost of capital.

The median earnings growth of PSEi stocks last year was 11.6 percent, which is slightly lower than the 12.1-percent growth registered in the previous year.

But this year, because of the prolonged lockdown in economic activities, earnings growth will most likely fall to negative territory due to losses from lack of revenues and higher costs from supply chain interruptions.

The market may look cheap based on a trailing 12-month earnings at 10 times rice-to-earnings (PE) ratio but if the expected losses this year are discounted, the market may come out expensive.

While we don’t know how this virus is going to change consumer behavior after the crisis, it is possible that consumption demand may remain weak for some time because people may choose to stay home due to fear.

Because of this risk, market investors may require a higher required rate of return when they put their money in stocks. The higher return, which comes in the form of higher opportunity cost of capital, means investors will demand lower stock prices.

Given the risk and growth prospects of the market, can we say that the PSEi is overvalued?

One way to determine the intrinsic value of the market is by computing the inverse of the difference between opportunity cost and growth.

If we get the difference between the opportunity cost of PSEi at 12.28 percent and standard economic growth of 6 percent and inverse it, we will get a fair value PE ratio of 16 times.

But this was before the lockdown. If we assume a lower medium term growth of 3 percent by incorporating the impact of the pandemic, we will get a PE of 10.7 times.

Now, if the composite income of PSEi is 570 based on 2019 earnings at 10 times PE, a decline of 33 percent this year will mean lower income at 382.

If we apply the PE factor of 10.7 times against this income, we should derive a PSEi value of 4,086, which makes the current market level theoretically expensive.

Unless a vaccine is found and developed and the current crisis is contained, shutting down the economy for a longer time will continue to undermine market confidence, which will depress share prices in the short run. INQ