Does market optimism matter for successful investing?

It has been said that stock prices rise and fall based on expectations.

Investors pay more for stocks when market outlook is positive, but when market is disappointing, investors pay less for stocks resulting in lower prices.

Investors pay premium if they expect earnings will grow in the future. Such premium can be computed by deducting the value of a stock’s earning assets from its market price.

The resulting premium will represent how much the market is valuing the growth opportunities of a stock.

For example, at the height of coronavirus crisis, the price premium of Ayala Land was only 6.3 percent because its market price of P22.95 per share fell close to its earning assets value of P21.5 per share.

The low premium signified market pessimism on the stock’s growth potential given the uncertainties at that time caused by the lockdown measures.

But today, because of high hopes for recovery, even though the value of Ayala Land’s earnings assets has decreased to P12.10 due to lower earnings due to the pandemic, its stock price went up to P39.45 per share.

The huge difference between the market price and the earnings asset value suggests that investors are very positive about the stock’s recovery prospects that they are willing to pay a premium of 69.3 percent.

This kind of optimism mirrors a similar pattern in the Philippine Stock Exchange (PSE) Index. When the stock market crashed last year, market confidence fell to its lowest in history.

The average price premium of PSE Index stocks of 21 percent at the start of 2020 quickly disappeared during the market panic and turned to a negative 18 percent discount.

The market was so depressed that even after the PSE Index has recovered in the weeks that followed, the average price discount continued to worsen to negative 20 percent.

Such price discount reflected how anxious the market was about the future. In periods of uncertainties, pessimistic investors would bargain for lower share prices to compensate for the high market risks.

This year, with the vaccine rollout slowly coming within our reach, the stock market is hopeful of a faster economic recovery. The rise in share prices over the past months suggests that investors are more optimistic now about the future.

The average price premium has recovered significantly from discount to a premium at 27.2 percent, or almost the same level last year before the crisis happened.

Historically, if we are going to compare the current premium to the previous years’, we will find that it is still relatively low.

For instance, during the bull markets of 2014 to 2017, the average price premium was about 41 percent. Even after the PSE Index topped in early 2018, the average premium remained high at 42 percent.

If we assume that market optimism will increase average price premium further to 41 percent, we should expect the PSE Index to rise to 8,689 level this year.

It is interesting to note that about one half of PSE Index stocks have below average price premium, which should help the market move up if these stocks eventually recover.

Some of these are Aboitiz Power, which has a premium of only 5.6 percent; Ayala Corp, 26.9 percent; BPI, 17.3 percent and DMCI, 1.5 percent.

There are also stocks that are still trading at huge discounts. Some of these are Alliance Global, -27.5 percent; Emperador, -11.8 percent; Globe Telecom, -45 percent; Metrobank, -13.5 percent; PLDT, -45 percent and Puregold, -30.6 percent.

While we would like to see a nice recovery story for the stock market with the average price premium slowly reverting to the mean, we also need to be cautiously optimistic.

Because the market moves in cycles, there are risks that some sectors in the economy may recover slowly, which may limit the market’s premium.

This is what happened in 2019 when the average price premium collapsed to 20.5 percent because stock prices failed to increase significantly despite continued fall in interest rates.

But being aware of the market risks, while being confident of recovery, should help you manage your downside and prepare you for the big opportunities. 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 87th batch of RFP Program this January 2021. To register, email [email protected] or text at 0917-6248110.