What’s up with the Market?

This week, I give column space to my favorite investment advisor. He has written a long piece on his views on the recent volatility in the local equities market. This week, I share with you his views.

For the uninitiated, the general behavior of the local stock market is observed through monitoring the local stock index, the Philippine Stock Exchange composite index. The PSEi is simply an index composed of a basket of stocks, selected as being representative of the market in general.

Hot money and QE

First, let’s look at net foreign fund flows, the so-called hot money, and how it affects the PSEi. The movement of the PSEi exhibits a very high (direct) correlation to foreign fund flows. Generally, a higher net foreign buying produces higher percentage change in the PSEi.  Conversely, when foreign fund managers turn to net sellers, the PSEi drops.  

Note: This is basic economics. Positive flows indicates that there are more buyers than sellers and negative flows means more sellers than buyers. Most importantly for the Philippines, foreign funds are a significant portion of trading in the local stock market.

Year to date, foreign buying and selling remains significant at 52 percent and 50 percent of total value traded (of P1.1 trillion) at the PSE, respectively.

Hot money flows into emerging markets, the Philippines included, have been brought about by the low interest rate environment in most advanced economics. This decrease in interest rates stemmed from the quantitative easing (QE) measures in many advanced economies (US, Japan, many EU countries) who have been trying to recover from the global financial crisis.

The global decrease in fixed income yields in the developed economies in the past few years resulted in inward flows of money seeking higher yields to faster growing emerging markets, the Philippines included. 

As the US and other countries wind down QE programs and contemplates raising interest rates, money flows are now reverting back to the US and other developed countries.

Beginning in April this year, foreign investors in the PSE turned to net sellers selling by roughly P9 billion a month. During this period, the PSEi dropped from 7,940 at the end of April to 7,536 by June 17.  However, despite the net foreign selling totaling P27 billion from April, year-to-date net foreign buying still amounted to P20 billion.  For the period, the PSEi posted a 4 percent increase to 7,536. 

By contrast, from 2011 to 2014, net foreign buying totaled P219 billion for those years. As expected, the PSEi increased significantly in this period. This also means that any foreign funds exiting in the post-2014 period would be realizing profits, provided they sell while prices are high.

The important thing to note is that any development, locally or internationally, that may cause foreign fund managers to wish to reduce equity exposures in the PSEi would dampen the PSEi. 

It’s about the price

But why would foreign fund managers be exiting equity positions in the Philippines when the country is forecasted to post strong economic growth this year and in the following years?  World Bank and ADB, among others, forecasted that growth for the Philippine economy will be among the strongest in the Asean region and even in Asia?

Despite its status as an emerging-market economy, wasn’t the Philippines identified as among the most “resilient” countries (even ahead of China and South Korea) should another economic crisis akin to last decade’s Great Recession happen again? Wasn’t the Philippines also adjudged as the biggest winner in an era of cheap oil? 

Will all the above factors going for the Philippines, why would foreign fund managers head for the exits? The answer lies in the real foundation of stock market investing: understanding prices. 

Finance theory (and evidence) tells us that the stock market is a fairly efficient discounting mechanism--taking into account currently available information and even present and future events. Essentially what this means is that the price already takes into account investor expectations of how companies will perform in the future. This is why when unexpected events happen, a rapid adjustment is seen in prices.   

Q1 2015 year on year GDP growth and 2015 forward price earnings ratio forecasts for select markets are shown in the Table (Bloomberg data).

Studies have shown a direct link between stock market returns and GDP growth over the long term.  Note that the ratio of prices to earnings (PE) in the Philippine market is comparatively high, even taking into account GDP growth.

In fact, a combination of several valuation measures presented a foreign fund manager, who commented that the local market was “priced for perfection,” actually shows that the Philippine market is among the most expensive markets in the world. What he meant was that the current prices assume the most optimistic view of the future.

The PSEi also trades at significantly higher PE multiple compared to its historical average of 15x. The PSEi traded at a PER of 23x at its peak in March this year!    

To compound this, GDP growth in the first quarter of this year was a relative disappointment at 5.2 percent, the lowest quarterly growth since the 3.8 percent registered in Q4 of 2011 and a far cry from the Philippine government target of between 7 percent to 8 percent growth.

Now what?

Obviously, this is not a comprehensive analysis. Investors must stay tuned to developments as investment is always a matter of balancing risk and reward, and making informed decisions. Understanding key drivers and monitoring key risks is critical.

Philinvestor’s Corner believes that investors should consider taking a relatively less aggressive position on investments. Taking some profits on equity positions and lightening up on large cap issues where foreign investors have and are expected to keep significant positions may be prudent. Selling on rallies and buying on dips may be considered. Of course, investment decisions are personal and should take into account individual risk profile, investment objective and time horizon.

So here’s my take on this: In a market priced for perfection, what happens when the inevitable mishap occurs?


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