Dear Clients,
Greetings of the day. Looking at the current market situation, I thought it would be wise to share my views with all of you. While I am in touch with you through personal meetings and phone calls / messages, I think it would be better if I can put my thoughts into writing and share with everyone.
The year 2023 was a fantastic year for equity markets. While there was some correction in the first quarter of calendar year 2023, markets really took off for the rest of the year. The rally has continued till date in 2024 as well.
Whenever I look at the stock market to gauge its present levels, I look at 3 things. 1) Valuations in terms of earnings growth, 2) Liquidity, and 3) Sentiments. I believe the first two are not bad, but the sentiment part is getting frothy and risky. In this brief post I would like to share my thoughts on the first two. I will cover the sentiment part in my next post, as I would like to discuss that portion in some more detail.
Valuations:
The short answer is “Valuations are not cheap”. When you look at the median PE and PB ratios, they are on the higher side if you compare them with the last 10 years of historical averages. If we go back further (2008 – 2013), the valuations are outright expensive. We need to remember that Valuations are a function of “ROE” (ROE > Cost of Capital creates value and ROE < Cost of Capital destructs value), “Growth” (Growth that comes with ROE > COC is valuable otherwise it is destructive), “Reinvestment” and “Discount Rates”. Without getting into the technical aspect, we need to remember that High ROE, Growth and Reinvestment with Low Discount rate will fetch higher valuation. On top of that, highest delta (sudden rerating of the stock or sector) happens when the company / sector shifts from ROE < COC to ROE > COC in other words, when the company’s ROE surpasses its Cost of Capital after a prolonged period. This is exactly what is happening with Defense, Railways, and other Public Sector companies. Due to the push from Government (in terms of high capital allocation to these sectors), and a prolonged under performance (Public Sector Undertakings collectively gave -18% returns from 2008 till 2020), in last 1 year and 3 years, various public sector undertakings have performed very well compared to other sectors of the market. I feel it is time to be cautious about them going forward. Future growth for at least the next 2-3 years has been factored in current prices along with the turnaround in higher ROEs. Slowly but steadily the good narrative is going ahead of the numbers that these companies can actually deliver.
Sectors (Market Cap) that are Overvalued: Defense, Railways, PSU Banks plus hyped up Small & Mid Caps
Sectors (Market Cap) that are Undervalued or Fairly Valued: Private Sector Banks, IT (some IT product companies are expensive), Oil and Gas, plus Large Caps.
Liquidity:
There are 3 ways liquidity increases in the stock markets. One, when the interest rates are lower, two, when there is higher government spending, and three, when there is FOMO (Fear Of Missing Out). Higher liquidity expands the PE and PB ratio and vice versa. I will talk about the first two and reserve the discussion about FOMO for the next part as it is directly related to Sentiments.
Lower interest rates are the most direct source of higher liquidity in the stock markets. When the Central bank lowers the interest rates, new bonds are issued at lower coupon rates which makes investing in equities more attractive. A prolonged period of low interest rates brings the discount rates lower. We know that lower discount rates mean higher valuations (all else equal). After the Global Financial Crises, the US central bank kept lowering the interest rates in order to push high growth and high inflation as it was worried about a deflationary spiral. And after Covid the US Government started spending like there was no tomorrow. So even though the US central bank started raising the interest rates (which should have decreased the liquidity in the equity markets), US government spending kept the liquidity higher and after a sharp but brief correction, markets kept rallying. This prolonged infusion of liquidity by the US central bank and US government has kept PE and PB multiple higher. If you ask a 3-year-old or a 5-year-old equity investor, he or she will say that 30 times PE or 3 times PB are cheap. This worries me. It tells me that almost all the good things about India (the growth, high ROE, longevity, etc. are currently priced in).
From the economic growth and longevity point of view, India is one of the best performing large economy in the world today. On top of that it seems that we are also going to have continued political stability at the Centre. Finally, due to exceptional returns in the last 2-3 years, there is a continuous flow of retail investors in the market. All of these have contributed to higher equity markets. Hence, I feel we are not going to face any major fundamental problem in the economy, at least from the domestic side (Oil is something that we will have to keep in mind).
So, do I think there is a crash coming? I don’t know. But risks are emerging from higher valuations in some sectors, and in small and mid-cap companies, and crazy sentiments of the investor community. When people start thinking that 10% or 15% per month returns are normal, it is time to step back and reflect. Take a Reality Check. Please stay away from loss making, high PE (without growth or free cash flows), highly hyped companies. Please stay away from leverage. 10% or 15% per month returns are not normal.
I will follow up with my thoughts on sentiments in my next post. Please feel free to connect.
