Can the stock market predict the economy?

The stock market has long been regarded as a leading indicator of a country’s economic health. It is often used as a barometer to gauge the direction of the economy.

When the stock market experiences a significant drop, it is often seen as a reflection of investors’ concerns about the economy’s future performance.

For example, if investors believe that a recession is coming, they may start to sell off their stocks in anticipation of lower company earnings and a weaker economy overall, leading to a downward trend in the market.

On the other hand, when investors believe that the economy is going to grow, they may start buying stocks in anticipation of higher company earnings and increased economic activity, causing stock prices to rise and lead an upward trend in the market.

Stock prices can rise and fall based on market expectations. These prices reflect the perceived value of a company’s future earnings potential, and changes in these prices can be an essential indicator of market sentiment and expectations for future economic performance.

One way to gain insight into the direction of the economy is by measuring market expectations. By analyzing the implied premium or discount that investors are currently paying for stocks, we can get an idea of where the economy may be heading.

When investors pay a premium, it means they are willing to pay more than the current market price, believing that the stock does not accurately reflect the true value of the company, and therefore has the potential to increase in value in the future.

But when investors pay a discount for stocks, it means that they have concerns about the future prospects of the company’s earnings growth or the growth of the broader economy or industry in which the company operates.

If we analyze the trend of market expectations in recent years, we can see that the average premium paid by investors for stocks has steadily increased from a low of -18 percent during the height of the pandemic to 40.3 percent last year, indicating a growing level of optimism in the market.

However, with the recent rise in inflation and interest rates, the market has become riskier, which caused the average premium to fall to 26.5 percent today.

If this trend will continue and market risk continues to increase, there is a possibility that the average premium could further decline, which could bring the Philippine Stock Exchange index (PSEi) to fall to lower levels.

Let’s say the average premium eventually reaches zero; we can estimate the PSEi level by multiplying the current level of 6,578 by 26.5 percent to calculate the premium value.

We can then subtract this premium value from the current level to obtain the target PSEi level of 4,834.

But how likely is it for the average premium to fall?

If we examine the level of market expectations on a per sector basis, we will discover that the current levels of the different PSE indices already reflect an implied discount.

For instance, the majority of bank stocks that are part of the PSE financial index are currently trading at an average discount of 56 percent. This suggests that investors have a negative outlook on the banking industry’s future, even though the industry posted double-digit earnings growth in the previous year.

Similar observations can be made for stocks in the industrial and property indices despite both having positive single-digit earnings growth in 2022.

The current prices of stocks in the industrial index suggest that investors are paying an average discount of 48 percent, while for stocks in the property index, the stock prices indicate an implied discount of 38.9 percent.

The only sector that continues to be positive is the services sector. Investors seem to be more optimistic about the services index compared with other sectors.

The current stock prices of companies belonging to this sector imply a premium of 48.6 percent. This could suggest that investors are confident that the services sector’s earnings will remain resilient even during an economic slowdown.

While market expectations are not a crystal ball for predicting future economic performance, they can provide valuable insights into market sentiment and expectations for future growth prospects.

Understanding market expectations can be an essential tool for investors and analysts seeking to gauge the pulse of the economy.

By analyzing the market’s collective views through the implied premium and discounts of current stock prices, investors can make informed investment decisions and strategies. INQ

Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools were provided by First Metro Securities. To learn more about investment planning, attend the 101st batch of RFP program this May 2023. To register, email [email protected] or text 0917-6248110.

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