Can liquidity & excitement defy valuations?

Nifty is at all time high reaching almost 11100- and we are not alone, across the world, stock markets have witnessed an unprecedented rally in 2017.There are very few instances in history where we have seen such bull control over the markets across the world for such a long time- with almost non-existent correction intervals.

The only difference this time around is- there is hardly any major risk that anyone sees except sudden geopolitical developments, Chinese debt crisis, liquidity squeeze in Europe/US/Japan, a black swan event or suddenly-everyone-waking-up-to-the-stretched-valuations, which is getting reflected in fairly low levels of volatility for a fairly long a time.

While there are local reasons, for at least a good part of the valuations of the equities in Europe & in USA- starting from improving economy to better corporate earnings to favorable tax reforms- Indian markets remained too bullish & over-bought despite of any of such signals- purely on the back of imported optimism, home-grown support of liquidity & unprecedented trust in the government’s ability to support economic growth- or at least the stock markets.

Nifty is trading at a PE multiple of almost nearing 28, while multiples on their own do not tell us much about how much over/under-priced an index is- but if the underlying stocks belong to the traditional industries or are not poised for any possibility of earning super-normal profits; then the index ideally should also trade at a comparative/historical range- or should trade at valuations basis non-comparative methods, which though might require much more efforts to value, but will certainly be much fairly lower than the current levels.

Historically every time the Nifty PE crosses 24 it corrects/crashes- while there is no such strong correlation seen with the CAPE ratio, which looks moderate at the moment & suggests that the markets are not that overpriced, though certainly are moving in that direction: 

The only way that the market can continue at such high levels is- if the earning catch up significantly in the Q3 & Q-4 of FY18 & thereby rationalize the multiples a bit- essentially the EPS for the index should go up by at least 20-25% by the end of the current FY & comparable growth in the earnings to continue thereafter. Another surprise that can moderate the valuations a bit, could be the corporate tax reduction/rationalization from the current levels- a delta of +5-7% to the earnings can come from the tax reduction.

But what has led to this bull-run in the Indian equities in the absence of any major thrust in terms of either macro or micro economic indicator:

Limited Supply of Investible Stocks: While we might have more than 5000 companies listed, there are just about 300-400 stocks that are worth investing in from the stand point of institutional investors because of the size of market cap & the stock liquidity. Even for the retail investor the over-all universe of stocks is not more than 400-500 because of lack of corporate governance & limited researchers/analyst following the stock - this limited supply often push up the prices & the headline index whenever institutional investors show interest in the Indian equities or the retail investor suddenly rush to catch the running bus.

New entrant to the equity markets NPS & EPFO might end the current FY with an investment of 10-15000 crore in the equity market & most likely will be putting in anywhere between 40-50000 crore in the next FY. A fresh source of liquidity chasing the same set of very limited number of stocks.

Retail Investor often on-board the bull run after it has already covered the initial distance- currently retail investors are contributing to approx. 5000 Crore of SIP mutual fund investment every month. The AUM of MF has more than doubled in just about 3 years to more than 22 Lac Crore. The mutual funds were sitting on cash when the Nifty crossed 9000 hoping for correction- it never happened & as it often happens with investors, they worry less about making losses than about missing a moving bus- the mutual funds started pouring money back at even higher valuations. Even the ULIP revival indicates the same- most private players have more than 50% of their new business premium coming from ULIP- an insurer working as a mutual fund; welcome to the pre-2008 times.

Modi Hope Premium: The market gives a thumps up, every time a stable government is elected with comfortable majority- election of UPA in 2009 led to a single day gain of almost 18% in the indexes. The market responded even more positively to the victory of NDA in 2014- with high expectations in terms of economic reforms & better governance/regulations. Though the Modi government is moving in the right direction but there are ample questions on the execution front. There are hardly any signs of significant improvement in the economic prospects- we grew at 6.7% in the last year of the UPA & we are growing at +6% in the penultimate year of NDA II. 

Easy Liquidity sponsored by central banks world over- the bit-coin rally to $20,000 is an indicator of what all easy money can do to an asset class. We have input pending from BOJ & ECB on quantitative easing & mostly they will continue with it, till the signs of recovery produce more evidences. Central banks across the world have injected more than $13,000 billion since 2008- one day they will have to pull back.

Subdued P/B ratio- indicating below par ROE for most of the index constituents- indicating scope for better earnings without much fresh asset/capital requirement.

So can this bull-run continue & if yes, the how long?

Perhaps it will, until it finds an excuse to correct itself. A few reasons why the markets would:

Subdued Corporate Earning: the corporate earnings have been stable since 2014- perhaps the only time in the last 15-20 years where the corporate earnings remained this subdued for 3 years- even during 2008 financial crisis the earnings recovered in less than 2 years. The slightly better earnings seen in Q3 FY18 might continue in Q4 too, but we have to compare that against a fairly low base of H2 FY17. Some of the sectors have moved to a lower orbit in terms of the profitability levels for varying reasons- thereby might contain the earnings growth. A few industries where the earning revival might not be as smooth as the market is expecting:

a.      Petroleum companies bottom-line depends strongly on the global crude oil prices

b.     Banks though might be showing signs of recovery in terms of profitability, but their asset quality is still under stress- on 22nd Jan 2018 Crisil published a report that puts the bad assets above 9.5 Lac Crore from the expected levels 8 Lac Crore.

c.      Telecom companies might continue underperforming for at least 2-3 years until the consolidation is completed & the Jio effect is stabilized.

d.     FMCG companies are perhaps the most expensive segment, which will continue facing challenges from Patanjali & from other regional players- putting pressure on both top & bottom line.

Economic Growth even if we take on face value, all the contradictory numbers that are published- still remains sub 6.5% with the GVA hovering around 6%. While anything more than +6.5% is not a bad level of economic growth, but looking at the global economic growth rate expected in the range of ~3.5%, the 3% delta is hardly as attractive as it was a year or two back. Additionally with a country that has sub $2000 per capita income, lower economic growth poses other challenges/risks too to the economic environment. We can’t build a consumption story basis this level of per capita income- if we look at the PCI for the bottom 2 quartiles the numbers are even worse.

Fiscal Deficit, though the government promising to keep within 3.2% & reducing it to 3% by next fiscal- it does not look like achieving the same, unless tinker with accounting entries; the recent divestment of HPCL stake to ONGC just puts the deficit from the books of the government to the books of the government subsidiary. Considering the pace of indirect tax collection, impending elections, rising crude oil prices & growth expectation in the next FY- possibility of achieving fiscal deficit target looks difficult, which might also keep the government from reducing the corporate tax rate significantly.

Commodity Prices have already started moving up, which might help some stocks to report better top line numbers but it would impact the bottom line negatively for most of the stocks.

Crude Oil prices inching closer to $70, which would negatively impact most of the nifty stocks, except a few. Additionally it will put upward pressure on inflation, resulting in possibility of earlier rate hike, fiscal deficit escalation & worsening current account balance. Also the windfall gain that the government had during the last 2 years because of low crude oil in the form of subsidy burden- mostly will be missing henceforth.

Nihilistic Buoyancy: market has already factored-in every possible positive event that can come about in the next few years & beyond; & it has nihilistically neglected any negative news that has come in the last year or so, which ideally leaves the market with very limited scope to react to any surprise positive event- though it might still do, but there are far more negative shocks that can rock the boat. The market, it looks, has already factored in NDA III with comfortable majority, peace in Korean peninsula, middle-east stability, stable currency, controlled inflation, reasonable global economic growth, sustained liquidity, trade barriers continue coming down- one day, one or many of them can throw a surprise; we are exposed to limited upside with fairly significant downside risk. Trump slapped steep tariff on washing machines & solar panels making China & S Korea unhappy y’day- just before i was finishing writing it.

Liquidity Squeeze: It is inevitable, what we are waiting for is- when? If they do start the tapering within 2018, it would lead to healthy corrections across asset classes & if they delay the pull back, we will have a crash later.

If you study the economic/financial trends more in details there are many more reasons that indicates- there is something not alright with the asset valuations; short/long term bond yields gap, GDP-tax mismatch, unemployment levels (high for India; too low for US, often results in impending slow down), distorted stock valuations because of tax structures etc.

Conclusion: The market, if not overvalued, is certainly very expensive at these levels. The excessive liquidity both domestic & foreign has been keeping the market ticking up & it might still continue for sometime before the valuations encounter reason. The dangerously cheap liquidity & idiotic optimism is so palpable- that on the announcement of Kodak launching its own crypto-currency Kodakcoin, the stock went up by more than 300% in 2days. The stock markets would see a correction- in the absence of any other event- it may be triggered by the central bank’s pull back in the next 4-5 months. Look out for July-Aug 2018.

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