Exuberance may be rational, but err on the side of caution


“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?       –  Alan Greenspan

Greenspan gave the above warning about a looming asset bubble in the US in the speech on “The Challenge of Central Banking in a Democratic Society” delivered at the Francis Boyer Lecture of The American Enterprise Institute, Washington D.C. on 5th December 1996. In spite of this warning by the one of the most shrewd and knowledgeable among experts, the market continued its rapid ascent for three more years. By the end of 1999, the inflation-adjusted Nasdaq index was 4,106—three times higher than when Greenspan had issued his warning. That’s how ‘Mr Market’ behaves. However, Greenspan’s concern came true in 2000 when the Dotcom bubble burst.

As the Dow, Nasdaq and S&P are setting new records and the Sensex is flirting at kissing distance of 40000, it is time to be concerned about the exuberance in the market. Whether this exuberance is irrational or otherwise, only time can tell.

After the global rally in stocks in 2017, most markets have either retreated a bit, or consolidated, so far in 2018. As on 30th August, the MSCI All Country Global Index is up by 2.2 percent in dollar terms, thanks mainly to the robust performance of the mother market US, which is up by 8.7 percent. The EMU, UK, Japan and EM indexes are down by 0.8 percent, 2.7 percent, 3.8 percent and 3.3 percent respectively in local currency. Out of the 27 major markets, only 9 are in positive territory whereas 18 are in negative territory as on 30th August. The mother market US is powering ahead. India is among the best performers.

US economy firing on all cylinders

The US economy is firing on all cylinders. In spite of the trade skirmishes, the $19 trillion giant has grown at a robust 2.2 percent and 4.2 percent in Q1 and Q2 of 2018. Earnings growth at above 20 percent is excellent. In brief, the rally in the mother market is backed by fundamentals; the exuberance is rational.

Back home, even though growth is back and likely to sustain, earnings growth is not yet good enough. Record levels of Sensex and Nifty raise the question of valuation. Are the markets getting over-heated? As always, there are both bullish and bearish views. Going by valuation metrics, Indian stocks are over- valued. The trailing Nifty PE is around 28. Valuations of mid-and small-caps are higher than historical averages. Also, the premium for Indian stocks is at historic highs to valuations of EM peers. This raises concerns of valuation. The bearish view is that these high valuations can’t be sustained and therefore a correction is imminent.

Indian economy bouncing back

However, it is important to understand that valuations have to be seen and assessed in context. At the height of the bull market in 2000 and 2008 PEs were around 28. But these two peaks were followed by global market crashes and economic contractions. Earnings growth also suffered. That led to prolonged downtrends in the market. But presently, India is on the cusp of growth and earnings recovery. GDP growth, with 8.2 percent in Q1 FY 2019, is bouncing back. 20 percent plus earnings growth is the base case in FY 2019 and the prospects for sustaining this earnings growth look bright. Viewed from this perspective, the present valuations can be justified. In retrospect, the present stretched valuations would appear fair.

The TINA and FOMO factors

The most important factor contributing to the resilience of the market is the strong domestic appetite for equity. The TINA (There Is No Alternative) factor is playing strongly in favor of equity. There are no attractive alternatives for investors. Poor returns from other asset classes like bank FDs, real estate and gold have made stocks and mutual funds attractive. This trend is likely to continue. New investors who started investing during the last few years, particularly through the SIP route, have tasted the superior returns from equity; and stories of superior returns are attracting new investors to the market. Thus, new investors are coming every day (around 31000 equity mutual fund folios are added everyday) for Fear Of Missing Out (FOMO). Thus, TINA and FOMO factors are reinforcing each other imparting great resilience to the market.

Triggers for correction

Since markets are priced to perfection, the risk-reward ratio is skewed towards risk. The consensus view that Fed tightening and the consequent capital flight to the dollar would be the trigger for correction has not played out. Even the trade skirmishes, which can impact global growth and trade, have not impacted markets. So the trigger for correction is likely to be a presently unknown factor. ‘Known unknowns’ rarely impact the market; the damage is done, more often than not, by ‘unknown unknowns’.

The current economic expansion in US, which began in 2009, is the 2nd longest in history; if it continues for 11 months more, it will be the longest since 1850. This economic expansion may continue further, extending the current bull market, which has become, this August, the longest in history. But the history of economic and market cycles teaches us to be cautious.

Domestically, since elections are drawing closer, sooner than later, political developments will start impacting markets. The market has not yet discounted a non-NDA government. The probability of the continuance of the Modi regime has come down to around 50 percent from near certainty a few months back. As elections approach the market will start getting nervous. High crude prices, fiscal slippage and election eve populism are other concerns.

In sum, the turnaround in economic growth, the uptick in earnings growth and the sustained flow of money into the market are likely to impart resilience to the market and keep it buoyant. This rally may surprise even the optimists. But valuations are a matter of concern. Therefore, even while remaining optimistic, investors may err on the side of caution.

First appeared in Economic Times

Posted: September 2018


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