Globally stock markets are at record highs with rich valuations. It is important to understand that this is a global rally driven primarily by unprecedented huge liquidity and low interest rates. Further moves in the markets also will be global. Short-term investors are a confused lot; not knowing whether to buy, hold or sell.
Method in madness
The economy-market disconnect has been discussed and debated extensively. To the lay observer of markets, ‘booming markets in crashing economies’ is indeed a puzzle. But the fact is, there is no puzzle in this. In fact, there is a ‘method in the madness’. The leading central banks of the world, led by the Fed, have injected around $20 trillion dollars into the global financial system. Cheap money policy is the right response during recessions and therefore, an ultra-loose monetary policy is justified during this severe global recession. Since consumer price inflation has been conspicuous by its absence in the developed world, this injection of huge liquidity has created ‘asset price inflation’ or in simple language, stock market boom. Historically low interest rates have accelerated the switch to equities. Alternate investments, except gold and some crypto currencies, have performed poorly. Therefore, investors chasing stocks is a rational pursuit.
Every crisis throws up its winners and losers. This pandemic- triggered crisis has proved to be manna from heaven for many businesses. E-commerce, telecom, pharma and IT are firing on all cylinders and are set to report record profits. Hence, it is rational that lot of money is flowing into these performing segments. Therefore, even though the disconnect between crashing economies and booming markets might appear as a puzzle to the lay observer, the fact is that there is a method in this madness.
Some irrationality in exuberance
Even though the pursuit of recession-proof growth stocks is a rational action, there is an element of irrationality in this exuberance. Liquidity and the TINA (There Is No Alternative) factor have pushed valuations high. PE ratios of many growth stocks are at unsustainable levels. At high valuations chances of sharp corrections are high.
Where do we go from here?
Markets have an uncanny ability to surprise. This rally has dodged even the market legends like Warren Buffet, Charlie Munger and Ray Dalio. Therefore, instead of attempting a trend prediction let me try to visualize some possible merging scenarios.
This is a Goldilocks scenario. Here we assume that the recent breakthroughs in Covid-19 vaccines from Pfizer and Moderna, and from some others expected shortly, would lead to containment of the disease. With the vaccine becoming widely available, there would be progressive unlocking of economies and sharp rebound in economic growth and corporate earnings. In this context, if inflation continues to be subdued in the developed world, and interest rates remain at near zero levels, more money will chase stocks pushing up stock prices further. Emerging markets like India will attract more capital flows. This is already happening. As on November 26th, FII inflows are Rs 58690 crores. This is a record for monthly inflows. This kind of liquidity can surprise on the upside.
This scenario factors in the logistical constraints in scaling up the production of vaccine and making it available on an adequate scale. Meanwhile, if the second wave of Covid attack which is already bad turns brutal, it might necessitate further lockdowns. This will adversely impact the expected economic recovery. Such a scenario may not lead to a sell-off in the market. Instead, the market is likely to consolidate in a range around the current levels.
This is a bear case scenario. A sell-off is possible in stock markets globally when the economic trigger that led to the rally – liquidity infusion by the central banks – reverses. Sure, a reversal of the accommodative monetary policy is unlikely in the near future. But, if inflation starts rising, central banks would be forced to taper the bond purchases that they are doing now. The Taper Tantrum of 2013 led to sell off in equity and currency markets. A repeat of this scenario is likely if inflation reemerges in the developed world in 2021.
Which of these scenarios will play out will depend on how the crucial variables behave. So investors have to watch out for the developments on the vaccine front, the intensity of the second wave of the pandemic, inflation trends and interest rates.