What market sentiment is telling us about the stock market

The stock market is often described as a barometer of investor sentiment. Optimism and pessimism drive prices, and one of the simplest ways to gauge that sentiment is by examining the premium investors are willing to pay for stocks.

Let’s break down what this premium represents. A stock price can be thought of as having two main components: intrinsic value and the growth premium.

The intrinsic value is the present value of the company’s existing operations—what the company would be worth if it never grew again. This value is derived from the company’s current earnings, discounted at an appropriate rate that considers both the risk-free rate and the company’s specific risk profile.

READ: Understanding the Philippine stock market

The growth premium, on the other hand, is the additional amount investors are willing to pay based on the future growth they expect from the company. If investors believe a company has significant growth potential, they will pay a premium over its intrinsic value, with the expectation that the company will generate higher earnings in the future.

For example, take SM Prime Holdings. If we assume no future growth and value its current earnings (P1.39 per share) by discounting it at a hurdle rate of 11.8 percent, we arrive at an intrinsic value of P11.73 per share.

Now, consider that SMPH’s current market price is P32.90. The difference—P12.02 per share, or about 64.4 percent of its total price—reflects the growth premium investors are paying for the company’s future prospects. This premium represents the market’s optimism about the company’s ability to expand and generate higher earnings in the future.

Historically, the level of premium reflects how much confidence investors have in future earnings growth, and higher premiums are associated with more optimistic expectations. On the other hand, when premiums are low, it signals caution or skepticism about the market’s future prospects.

Over the past few years, we’ve seen how market optimism has affected stock price volatility. During the height of the pandemic, when uncertainty and fear dominated, investor sentiment turned negative, which led to a sharp drop in the average premium paid on stocks, reaching -18 percent.

When confidence returned after the pandemic, the average premium surged to 40.3 percent as investors anticipated a strong recovery. This increase was significant because it reflected not only optimism but a level of confidence similar to the bull market years from 2014 to 2018 when the average premium was around 41 percent. Essentially, the market at that time was pricing stocks as if it were returning to those prepandemic boom years.

Last year, when interest rates began to rise, the Philippine Stock Exchange Index (PSEi) dropped by 15 percent from its peak. During this period, the average premium fell to 33.6 percent. Although the stock market rebounded in the first quarter of this year, the average premium still declined to 28.6 percent.

READ: How to capitalize on the strength of the stock market

Today, we find ourselves in a unique situation: despite the market’s recovery, the average premium investors are paying has dropped to just 20.4 percent. This low premium signals a market that is far from euphoric.

Investors are pricing in modest growth expectations that reflect a mix of cautious optimism and a healthy dose of uncertainty. Several factors explain why investors aren’t willing to pay the higher premiums we’ve seen in this market rally:

• Rising real interest rates: Although the Bangko Sentral ng Pilipinas (BSP) has lowered the benchmark interest rate to 6 percent, the real interest rate rose to 4.2 percent from 2.95 percent in the previous month, as inflation fell to 1.8 percent. When real interest rise, it signals that investors require higher returns after factoring in inflation. This increase in real rates raises the discount rate used to value future earnings, which reduces their present value. As a result, stock valuations tend to decline.

• Weaker peso: The peso has depreciated against the U.S. dollar lately, which has increased fears of inflationary pressures. The weaker peso, together with rising external debt, may raise concerns about the country’s ability to sustain strong economic growth.

• Rising price of gold: Gold prices have risen steadily, which indicates investor anxiety about global market stability. As inflation remains and geopolitical tensions are unresolved, more investors see gold as a safe-haven asset. Investors may be buying gold in anticipation of future inflation, economic shocks, or currency depreciation.

• Fears of a slowing economy: While the global economy has been recovering, signs of a slowdown are becoming evident. Economic data showing slower-than-expected growth in major economies have raised concerns. China, a key driver of global demand, is experiencing weakening industrial output, lower consumer spending and challenges in its real estate sector, all of which are contributing to global economic uncertainty.

While the rise of the stock market may suggest confidence in the recovery, the shrinking premium serves as a warning. Historically, when premiums fall in the face of growing risks, it can indicate that the market is vulnerable to a pullback.

Investors would be wise to temper their optimism with caution. The lower premium being paid today suggests that the market believes the recovery will continue, but the risks ahead suggest the path may be more uncertain and volatile than the market currently anticipates. INQ

Henry Ong is a registered financial planner at RFP Philippines. Stock data and tools were provided by First Metro Securities. To learn more about investment planning, attend 109th batch of RFP Program this Jan. 2025. To register, e-mail [email protected].