The driver of equity markets in the long term is earning, in the medium term it’s liquidity, and in the short term it’s sentiment.
The earnings cycle of corporate India and the stock market cycles have their unique journey. There can be times when both the cycles coincide and move together. And there are also times when they both are completely disconnected and move on different paths.
To understand this concept of why markets are moving up when the economy is still recovering, one has to understand the concept of discounting or pricing in of information.
Markets are forward-looking. They look at information and start pricing them, keeping the focus on the future. To understand this concept of how markets discount new information, let’s take the example of real estate.
Let’s say there are rumours of a new metro line project in the locality. Now even before the official announcement, just based on these rumours the prices of real estate in the locality will start moving upwards. The formal announcement by the government brings more cheer for the prices. It is also possible that the property prices move up so fast that they peak even before the metro work even begins. When finally, the metro is up and running, almost all positive benefits get discounted in the price. Now if a new investor plans to invest in real estate after the metro project is complete and expects the same high returns, he is probably making a mistake.
The same is true for pricing of other Equity, Fixed Income, or any other financial asset. In March last year in 2020, even before the government declared a three-week national lockdown on 24th March, the equity markets already corrected by more than 30%. Markets had started discounting the impact of the global pandemic. They started pricing in the GDP contraction, loan defaults, job losses, business disruption, and low corporate profits. Markets didn’t wait for these events to happen before correcting them. The equity market is forward-looking. They start pricing all available information good or bad. It is not that the markets are completely efficient in pricing all information. This is mainly because not everyone has access to information. Those who have information may not have the capability to decode this information and the most important factor is that during such times emotions also take control of our decision-making process.
In today’s information and technology age, it takes a fraction of a second to execute the trade from any corner of the world. An example, during the 2021 Budget when the finance minister announced an increase in FDI in the insurance sector, the stocks of insurance companies moved up immediately, discounting the new positive information.
Now let us try to decode why the markets have more than doubled from the March lows when the economy is still trying to come back on its feet. What is that the market is discounting or pricing in to move up so fast?
If in March 2020 the economy was left on its own, it might have taken the economy years to stand on its feet. The sudden global shock of a pandemic led to an extraordinary response from Governments & Central Bankers across the world. It was expected that governments will spend and carry a higher fiscal deficit and at the same time, central bankers will reduce rates and print money. But the speed and magnitude at which these actions were taken were unimaginable.
Today, interest rates are at historic low levels. The world has never seen such low-interest rates in recorded 5000 years of banking history. Warren Buffet says that interest rates are the most important thing in determining stock values. He further explains that interest rates are to asset prices what gravity is to apple. So, when there are low-interest rates, there is very low gravitational to pull asset prices down. So, when all Central bankers were reducing interest rates, especially the USA, Europe, and Japan markets were discounting this positive news flow. In India, the RBI reduced the repo rate to 4% and the reverse repo rate to 3.35%.
Most central bankers were printing money. The US alone printed approx. 3 trillion dollars in less than one month (approx. equal to India’s GDP). Liquidity is like water, it has to flow somewhere. Liquidity provided cheer and moved to risky assets. To understand liquidity, look at the auction amount at which IPL players are bought. The reason why Indian IPL players get a fat auction amount in comparison to similar T-20 premier league is because of the high liquidity which Indian franchises have.
Most governments spend a lot to provide a safety net to the people and the economy. The fiscal deficit of most countries crossed more than 10%. It’s generally during war time that governments raise such an extreme amount of debt. Government-supported with direct cash transfer, unemployment benefits, waiver of interest cost, loans to business, and a host of other welfare schemes. High spending from the government helps to kick-start growth in the economy.
The entire world’s focus was on the vaccine. And every positive news on the development of a safe vaccine was a positive for markets.
When most of the investors were looking at the real economy the markets were discounting at all these positive events. In March 2020 the markets were discounting a deep recession and now with low-interest rates, high liquidity, high government spending and the vaccine, the markets are expecting a sooner-than-expected economy revival and growth in the future.
This is a snapshot of the roller coaster ride of the last 12 months. As Sensex crosses 50,000 levels and markets have almost doubled from their low, the most important questions which Indian investors have in their mind are: Are Indian markets in a bubble? And, Where to invest in such a low-interest-rate environment?
In a Bubble, the valuations are generally high. The economy is overheated with high employment, wage growth, high corporate profit, excess leverage taken by both corporates and consumers. The stock market returns of the last couple of years are much higher than the average equity returns. There are new IPOs getting listed every second day. There are high listing gains for every IPO. There are excess greed and euphoria in the market and animal spirit is in full swing.
Take a look at the Indian markets currently. On the returns front, Nifty since the peak of Jan 2008 has barely managed to give returns higher than fixed income. On the corporate earnings front, the last decade has been a whitewash. The earnings per share of Nifty companies on an aggregate level in the last 10 years have been less than a savings account of 4%. There are a few IPOs getting listed, but these are in mid and small-cap space. Since the size is small, with some euphoria the stocks are moving up on listing gains. Mutual fund data shows that most categories have net negative flows i.e there is more redemption than fresh inflows coming in equity mutual funds. Corporations are borrowing very selectively despite low-interest rates. This doesn’t seem like a Bubble.
If one looks at the Indian economy, it seems we are near the bottom of the earning cycle. With low-interest rates and ample liquidity, there should be strong growth in earnings for the next few years.
Possible strong earnings growth makes a good case for equity. But as we already discussed discounting, the markets know this and are already discounting this information.
The current equity market is neither over-valued, nor they are undervalued. If on one side one is worried that prices are high, the comforting fact is that there is a potential for strong earnings growth in the future. If one plans to invest now, one should enter the market with moderate expectations of returns in the future.
Today interest rates are low. The odds of interest rates moving up from here are much higher than interest rates coming down further. From a fixed income standpoint, it makes sense to be invested in a high-quality AAA-oriented short-term debt portfolio.
Gold at any point in time is a good hedge for uncertainty. Having 5% to 15% in gold at all times is a good option.
Emotions and Regret
Some investors regret not buying during the March 2020 lows. If one recalls March 2020, the fear was real. Markets corrected by ~36% in approximately 21 trading days. Markets have never corrected at such a pace in the past. It almost felt it could be a repeat of the 2008 global financial crisis. If the Central Bankers & Governments across would have not taken the necessary action, it might have been a different story. All market falls look like a great buying opportunity only in hindsight.
Some investors are sitting with cash to invest, but are waiting for a correction. This reminds me of an interesting quote from a legendary fund manager Peter Lynch, who says, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections than has been lost in corrections themselves.”
And some investors are redeeming their money as they are seeing some profits in their portfolio and cashing in the gains. These investors will most likely come back when the markets move up by 15-20%. So what was the point of redeeming? Classic emotion of taking action just for the sake of it. Some investors are also jumping into equity by taking a high risk due to FOMO (Fear of missing out). The quick gains in the equity market.
Financial decisions should be taken with a well-thought financial plan. One should learn to build one’s portfolio which is in line with one’s goals, personal circumstances, time horizons, risk appetite, and psychology. That’s the approach which would help one to not just survive these market phases, but also thrive.
(By Amit Grover, AVP for Learning & Development at DSP Investment Managers)