Why investors want more now
Stock prices often appear difficult to explain. They move daily in response to news, interest rates and changing expectations about corporate earnings.
Yet behind this constant movement lies a simple economic principle that ultimately anchors stock valuations: the return investors demand for taking risk.
That required return is captured in what economists call the market risk premium, the additional return that investors expect from equities compared with risk-free government bonds.
When investors feel confident about the economy and corporate earnings, they accept a smaller premium. When uncertainty rises, they demand a larger one.
In that sense, the market risk premium provides a useful window into investor sentiment.
Now, to understand how this concept works, let’s consider this simple example. If International Container Terminal Services Inc. (ICTSI) trades at a price that implies a price-to-earnings (P/E) ratio of 25 times, this translates to earnings yield of about 4 percent.
If we assume that its earnings will grow roughly in line with the Philippine economy, which is about 6 percent annually, the total return that investors expect from owning that stock would be about 10 percent. This expected return comes from combining the earnings yield with the assumed growth in profits.
Investors, however, always have an alternative. They can invest in government bonds, which are considered virtually risk-free. Today the yield on the Philippine 10-year government bond is around 6.2 percent.
If ICTSI is expected to deliver about 10 percent, while government bonds offer roughly 6.2 percent, the difference of about 3.8 percentage points represents the market risk premium. This is the extra return investors demand to compensate for the uncertainty of owning ICTSI’s stock instead of lending to the government.
In this case, the relatively small premium reflects the market’s confidence in ICTSI’s prospects, which allows the stock to trade at a higher multiples of 25 times earnings.
But not all companies enjoy the same level of confidence. Across much of the market today, investors are demanding significantly higher premiums before buying stocks.
When this same approach is applied across the companies that make up the Philippine Stock Exchange index and adjusted for differences in risk using beta, we can infer the implied market risk premium embedded in current stock prices.
In effect, it tells us how much additional return investors collectively require to hold equities rather than risk-free assets.
The movement of this premium over the past several years tells a revealing story about how investor sentiment has evolved.
At the height of the pandemic in 2020, when economic activity collapsed and uncertainty dominated financial markets, the market risk premium surged to about 12.5 percent. Investors demanded unusually high expected returns before investing in the stock market.
But as the economy gradually reopened and confidence returned, that premium declined sharply. By 2021, it had fallen to roughly 7.2 percent, which showed that investors were becoming more comfortable with risk.
By 2022, optimism strengthened further when the risk premium compressed further to around 6.6 percent, one of the lowest levels seen during the postpandemic recovery. At that time, the market was pricing in a strong economic rebound and improving corporate earnings.
However, the environment began to change as inflation concerns and rising interest rates unsettled financial markets in 2023. The implied risk premium began to climb again to around 8.3 percent. As government bond yields climbed, investors once again began demanding higher returns from equities.
By 2024, the shift had become more evident when the implied market risk premium rose further to around 9.4 percent, which signaled that investors were becoming more cautious than they had been during the earlier recovery period.
Today, amid rising global uncertainty and persistent domestic concerns, the implied market risk premium embedded in stock prices has risen to roughly 11.3 percent, which is alarmingly close to the 12.5 percent peak reached during the height of the pandemic crisis in 2020.
This shift is significant. When investors demand higher returns to hold stocks, they become less willing to pay high prices. As a result, stock prices tend to adjust downward to restore equilibrium between risk and return.
If investor caution intensifies further and the market risk premium rises back to the 12.5-percent level seen during the pandemic, the required return on equities would increase accordingly. Under the same earnings and growth assumptions, simple valuation estimates suggest that the PSE index could fall to around 5,000 level.
This does not mean the market is destined to reach that level. But it illustrates how sensitive stock valuations are to shifts in investor sentiment.
In essence, the market risk premium reflects the level of confidence among investors. When caution rises, valuations tend to adjust accordingly.
Until confidence begins to improve, the Philippine stock market may continue to reflect the higher return investors now demand for taking risk.
Henry Ong is a registered financial planner at RFP Philippines. To learn more about investment planning, attend 115th batch of RFP Program this March. To register, e-mail at info@rfp.ph.
