RANDOM WALKER | It’s not yet the bottom of the stock market

All ageing bull markets eventually will “climb a wall of worry.” As stock prices keep rising, investors start to be anxious about whether the market has risen too high, too fast, and they start itching to hit the panic button. Who could blame them? Since hitting a market bottom in September 2011, the market had skyrocketed 91 percent without taking much of a breather until peaking in mid-May this year.

The point of no return has passed, however, for the sundry punters who thought there was only direction to the market. Since hitting an all-time high of 7,403 on May 15, the benchmark PSE index (PSEi) has tumbled around 14 percent, well beyond the 10 percent retracement that analysts consider as a “market correction.” Even at these current downscaled levels, the market maintains a year-to-date 10 percent gain above its 2012 closing. Not much of a consolation to those who entered near the market’s peak.

It also won’t be much of a comfort to most people that the market may yet retrace its steps to the 5,800-line. Things could get worse before they get any better. If that happens, then the market would have entered the technical definition of a “bear market,” which analysts delineate at a 20 percent retracement from the recent peak.

In this doom-laden environment it does not help much that market analysts quoted in the news turn to platitudes in place of real analysis. Analysts and expert commentators lately preamble their comments with “hopefully…” as if faith in the market would reward them with a rebound. These non-secular comments fail to enlighten the ordinary market investors who are losing a lot of money in this market correction and are asking one simple question: “What is happening?”

It would be facile to answer that “Shit happens” but that won’t be much of an explanation. This short piece will attempt to sum up the events that led to the current situation and will then try as best as it could to envisage the market’s near-term trend and the factors that will impel it.

To start off, it should be understood that foreign capital inflows have been the main propellant for the hefty equity markets gains in the region, including that of the Philippines. Capital flows are broadly divided into foreign direct investment (FDI), portfolio investments, and other investments. FDIs remain the largest proportion of capital flows, and these go into real projects. Portfolio investments, on the other hand, have been growing in size and in proportion to the total capital flows pie. This is the portion that invests in stocks and bonds, making them short-term in duration and very volatile.

These capital flows are both boon and bane to the recipient economies. On the one hand, these flows boost consumption and increase welfare, and mobilize foreign capital to supplement domestic savings in fuelling local investment. On the other hand, these volatile capital flows are subject to “sudden stops.” Booms in capital flows from abroad often end the cycle with a “sudden stop,” as capital flows abruptly reverse and, in the ensuing heavy outflow, the domestic currency suffers a sharp depreciation, local asset prices plunge, and the economy endures financial stress, possibly leading to a debt and liquidity crisis, and widespread corporate bankruptcies.

Push and pull

There are so-called “push” and “pull” factors that have driven fund managers from developed economies to invest in the emerging markets of developing economies. The “push factors” refer to the extremely loose monetary policies in the developed economies, where benchmark interest rates are close to zero, with the resulting low returns leading funds to hunt for higher yields elsewhere. They found it in the emerging markets of Asia.

The “pull factors,” on the other hand, consist of the relative resilience of the developing economies despite the recent global financial crisis (GFC) as well as the region’s policy of economic liberalization and opening their markets to foreign participation. In the Philippines, the improving economic fundamentals—the credit rating upgrade, the record high economic growth, among others—serve as prime examples of “pull factors” for these foreign funds.

Another thing to consider is that the Philippine equity market is not an island, “entire of itself.” The local market is fast becoming integrated with the global and regional markets. Empirical studies indicate that capital (bonds and equity) markets in Asia are more globally integrated than regionally integrated. What does that mean?

Integration of capital markets refers to a process in which the returns of assets of similar maturity will converge towards similar risk-adjusted returns. The bond and equity markets in the region, including the Philippines, are more attuned to developments in the developed economies than to developments in the region. Hence, they are more globally integrated.

This process of integration is driven by the so-called “law of one price,” a theory that states identical assets or securities should have comparable or similar risk-adjusted returns, assuming no administrative and informational barriers exist in the markets. Put simply, if two assets are the same, then they must have the same price or valuation.

This is the law that the Philippine equity market violated when it surged to new all-time highs, pushing valuations to their peak as well. Why buy the stock of a telecommunications firm in the Philippines when a similar telecoms stock in other countries would cost less? The too easy answer before was that the country was growing at the fastest pace in Asia, thereby justifying the price-earnings (P/E) expansion. This is the technical way of saying high growth excuses the market’s high valuation.

Quality growth?

Time to look closely at the numbers. The government reported that GDP in the first quarter grew 7.8 percent, the highest in Asia. However, growth in household consumption slowed and the slack was taken up by a 13.2 percent surge in government spending ahead of the mid-term elections in the second quarter. The slack was also filled by the 34 percent surge in construction demand. In a nutshell, this is not what one may call “quality growth.” Government spending growth, due to obvious limitations, cannot be sustained for long. Construction has been focused mainly on real estate, which is not a production investment in the sense that it does not create additional production capacity for the economy’s industrial sector. In fact, growth in investment in durable equipment during the quarter appeared to be slowing down.

In addition, the first-quarter results of some listed companies were not that encouraging. The power utility companies, for one, indicated that electricity volume sales were either flat or decreasing. A truly growing economy and high electricity sales growth ought to go hand in hand.

As to the push factors, the growing concern is that the US economy appears to be picking up, thus negating the need for the ultra-loose monetary policy. Most analysts expect the US Fed to begin tapering off its quantitative easing (QE) policy towards the end of the year; the doubling in long bond rates in the US already captures such fears.

Rising interest rates would lead to lower prices for stocks and bonds. Why? The technical answer is that the future cash flows of bonds (coupon payments) and stocks (dividends, earnings, and capital appreciation) would have to be discounted by a higher rate, thus resulting in lower present values. The more simple answer is that investors are attracted by the higher yields in relatively risk-free Treasuries and they thus sell stocks in favor of the safer haven of fixed-income securities.

One last factor that is driving equity prices is momentum. The market first abandoned the rationale of fundamentals reasoning when it kept soaring to mind-numbing stratospheric heights. Markets tend to do the same thing as panic ensues and sellers refuse to “catch a falling knife.”

In summary, although the second-quarter economic numbers will likely continue to be strong due to election spending, this will not likely be sustained in the second half and next year. Company earnings growth will also slow as a result. Meanwhile, the erstwhile positive “push factors” of loose monetary policy in developed economies could reverse as the year progresses. Finally, the technical picture of the market is quite bearish, indicating a possible retracement towards 5,800, near last year’s closing. This market correction, therefore, could potentially last another four to six months or so, by which time the market will start writing off this year as a total washout and begin looking at next year’s growth prospects. –Noel G. Reyes