Are the markets fairly valued?

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Globally stock markets have bounced back sharply from the March lows. Nasdaq and S&P 500 are at record highs. The MSCI Global Index is up by around 25 % from March lows. Nifty is up by 50 % from March lows. This bull-run, very different from previous bull-runs, has foxed even the famed market gurus. A roaring bull market amidst one of the severest recessions in history is, indeed, abnormal and optically irrational. But it is important to understand that we are living in abnormal times. Market valuations are determined by a complex set of factors and the complexity of these factors has increased during this unprecedented crisis. Economic growth and corporate earnings, which dictate valuations under normal times, have been eclipsed by the power of liquidity and the pull exerted by historically low interest rates. The disconnect between markets and the real economy is a fact; and the paradox of ‘bullish markets in struggling economies’ is unsustainable. Also, it is important to appreciate the fact that investors who remained invested during the market crash and those who invested systematically have gained substantially.  

Now, the important questions are: How are markets valued? Are the present valuations justified? Can they sustain?

At all levels of market valuations there would be optimists and pessimists. At excessive valuations, while some would sound the alarm and predict that the bubble would burst, others would come out with new theoretical justifications for the high valuations. The reverse also is true.  Even when stocks become cheap and valuations turn attractive, there will be skeptics warning investors of further crash in the market. Whether the optimism and pessimism were justified will be known only with the passage of time.

There are various parameters for judging the market valuations: PE ratio, Market cap to GDP, Price to book value and Dividend yield are widely used. The most popular is the PE Ratio. Some gurus like Warren Buffet emphasize Market cap to GDP. Going by the PE multiple, globally markets are overvalued. Nifty at 11300 is trading at

25 times FY 20 earnings, which is hard to justify from the earnings perspective.

Of course, valuations in India are justifiable from the Price to Book and Market cap to GDP ratios. Presently, the Price to Book ratio is around 2.5 and Market cap to GDP is at 0.76, both lower than last 10-year averages.  But it is important to appreciate the fact that in the mother market US, Market cap to GDP is excessive at 169 percent. On previous occasions when this ratio became excessive like in 2000 and 2008, markets crashed leading to a global rout. It is important to understand that globally markets are driven by liquidity and the fundamentals are weak.

During this pandemic-triggered global recession characterized by profound uncertainty, investors have to be cautious. The sharp spurt in Nifty by around 50 percent from the March lows has given big profits to investors who stayed the course and bigger profits to those who invested during the crisis. Taking some money off the table or shifting some money to fixed income may be considered.

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