The stock market has been declining for almost nine months now and there seems to be no end in sight, with the PSE Index already dropping 25 percent from its peak this year.

But if market history is any guide, the current downtrend in the market should soon be over.

ADVERTISEMENT

Based on recent major corrections in the market, the PSE Index has always recovered after losing at least one-fifth of its value from a prolonged downtrend.

In 2015, the PSE Index was losing 25 percent for eight months before it bottomed out and regained its losses. Similarly, in 2013, the PSE Index was also on a major downtrend, losing about 23 percent, but lasted only for seven months before it bounced back.

If the current rally is any sign, does this mean that we are finally seeing the light at the end of the tunnel?

While there is a good chance for the market to recover based on historical pattern, there is also a possibility that it may not follow the same path.

The market environment today is very different from what it was during the past five years.

For example, in 2015, when the PSE Index fell into massive correction, the interest rate, as indicated by the 10-year Philippine bond yield, was only 4.11 percent.

Interest rates were relatively steady during the period so that when the market started to recover after eight months, the rates were almost unchanged.

Unlike in 2015, this year, interest rates were rising from 5.5 percent to 6.04 percent when the market fell in January. Interest rates have continued to rise until today at 8.04 percent.

Rising interest rates make investing in stocks riskier.

ADVERTISEMENT

When risks are higher, the demand for returns also increases, which lowers share price valuations.

The movement of interest rate is negatively correlated with the PSE Index so that when interest rate rises, the market will fall and vice versa.

The degree of correlation with the stock market, however, differs considerably on the stability of interest rates.

For example, in 2014, when interest rates were stable at 4.3 percent, the correlation with the PSE Index was only at 1.8 percent.

But this year, with inflation rising and peso falling, the volatility of interest rates affects about 30 percent of the PSE Index’s movement.

The higher the correlation, the stronger the impact of interest rates on share prices.

Perhaps, for historical reference, we can compare the current situation with the environment in 2008 when interest rates were rising.

It was the global financial crisis. Interest rates were as high as 10.1 percent while inflation was climbing from 2.8 percent to 9.3 percent. The exchange rate, on the other hand, was soaring from P40.4 to P50.2 to a dollar.

During that time of extreme financial distress, the correlation between interest rates and stock market was 45 percent, which caused the PSE Index to lose by as much as 55 percent over a period of 15 months.

The market, of course, is far from being in a crisis, but this is the worst that could happen if interest rates continue to go up. The PSE Index can possibly extend its losses to over a year.

While the market may be historically low, which is trading at median Price-to-Earnings (P/E) of 15.4 times, share prices are still considered relatively overvalued due to the rise in interest rates.

The current 10-year bond yield at 8.04 percent is comparatively higher than the earnings yield of the market at 6.4 percent, which is derived by getting the inverse of the median P/E ratio.

Imagine if earnings yields must catch up with interest rates, the market should trade at 12 times Price-to-Earnings (P/E) ratio, which means share prices must fall by at least another 20 percent from the current level.

If the stock market were to recover soon, interest rates would have to come down significantly.

A lower interest rate will only be possible with the support of a lower inflation and a stronger peso.

The market, at some point, may need to take a combination of both yields, that is, a falling interest rate and rising earnings yield to prepare for a meaningful recovery.

Subscribe to Inquirer Business Newsletter

Read Next

EDITORS' PICK

MOST READ