Are we facing a stock market bubble?


Market history has shown that there is a positive relationship between investor sentiment and stock returns.

Stock prices tend to rise and generate excess returns when market sentiment is bullish, but when investors are uncertain about the future, stock prices tend to weaken and fall, leading to losses.

We’ve seen how market optimism has driven stock prices to rally over the past 12 months, on expectations of a strong recovery this year.

The average premium paid by investors on equities has increased since the start of the pandemic, from a low of -18% at the height of the crisis to 38.5% last year.

Now, with the economy returning to normal, the average market premium has risen further to 40.3%, indicating a positive outlook for investors so far this year.

By historical reference, the current market premium is almost back to its pre-pandemic levels, which averaged around 41% during the bull market from 2014 to 2018.

But in a market environment where there is a constant threat of rising inflation due to soaring global oil and commodity prices, not to mention a falling peso, paying a premium for the recovery in earnings d an action can be too risky.

In fact, an increase in the market premium along with an increase in inflation and interest rate risk indicates a stock market bubble.

Remember that the price of a share is made up of an intrinsic value and a growth premium.

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.

A rise in interest rates can make stocks overvalued by lowering their intrinsic value and inflating their growth premium.

For example, if we want to calculate AC Energy’s intrinsic value, we can simply discount its 12-month earnings per share of P0.12 by its opportunity cost of 9.2% to get a value of 1.30 P per share.

To estimate the stock’s premium, we can simply deduct the intrinsic value of P1.30 per share from its price of P7.88 to get a growth premium of P6.58 per share or 83.5% of its market value.

Now assume that interest rates will continue to rise. If the interest rate increases by 1%, the opportunity cost of the stock will also increase by 1% to 10.2%.

The 1% increase in the stock’s opportunity cost will reduce its intrinsic value by 10%, from 1.30 pesos per share to 1.17 pesos per share.

Since the intrinsic value is lower, the share of the growth premium in the stock price will be greater.

In this case, AC Energy’s drop in intrinsic value will inflate the stock’s already inflated growth premium from 83.5% to 85.1%, which could burst at any time during a correction.

If we apply the same framework to the entire stock market, how far can the Philippine Stock Exchange (PSE) index be expected to fall?

If the current market premium is 40.3% and the PSE index level is 7112, we can deduce its implied intrinsic value at 4248 by removing the premium.

If interest rates continue to soar in the coming days and the yield on the 10-year Philippine bond, which rose from 5.27% to 5.67%, continues to rise to 6%, the value intrinsic value of the PSE index could shrink to 4,113.

A lower intrinsic value of 4,113 compared to the PSE index of 7,112 will result in a higher market premium of 42.2%, making stock prices overvalued.

In theory, to restore the premium to 40.3%, the PSE index would have to fall to the level of 6,889, but in reality, when uncertainties begin to worry investors, the average premium may also fall.

If the market premium regresses to last year’s average of 32.5% with the interest rate dropping to 6%, the PSE index could fall as low as 6,093. INQ

Henry Ong is a Registered Financial Planner of RFP Philippines. Stock market data and tools provided by First Metro Securities. To learn more about investment planning, attend RFP Program Batch 94 in March 2022. To register, email [email protected] or text at 0917-6248110

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