The Nifty has more than doubled since its March 23, 2020 lows and there is no stopping it. The markets are moving up despite talks of a third Covid wave. Your view?
When the Nifty nosedived In March 2020, with scarce and scary information about the virus coming out of China, there was a question mark on the future of mankind and of cash flows of companies around the world. Expected long-term cash flows became highly uncertain with increased tail risk and the probability of many companies going bankrupt. Investors were worried that it was a bottomless pit, with the combination of a highly contagious pandemic and little hope of vaccine for years, leading to widespread long lockdowns and consequent irreparable damage to businesses. However, from late March onwards, more information started becoming available from around the world and prospects for the market recovered sharply even as infection numbers were climbing up. It soon became apparent that mortality rates might be a small fraction of a percentage point rather than mid-single digit percentage that was feared in early days. Leading global pharmaceutical companies started talking about positive preliminary developments on the vaccine front.
While these were early stage developments that are far from certain, the market has a probabilistic discounting mechanism which started factoring in the increased likelihood of vaccines in the near term. Now with the combination of reduced mortality and widespread vaccine availability, the pandemic is no longer a market crisis even though it remains a health crisis. Further waves notwithstanding, as long as vaccines remain effective against the various mutants, the pandemic has become history from the market’s perspective.
This is so because the markets represent the present value of long term future cash flows, which appear far less uncertain today than they did in March 2020. Over time, it is in the nature of markets to go up because of unwinding of time value of money and the underlying corporate cash flows going up. As long as GDP and corporate cash flows are expected to grow, the market will move upwards over longer periods of time, albeit with intermittent fluctuations to reflect changes in expectations of these long term cash flows and the applicable discount rates.
Hence, when measured over multiple decades, globally the markets have tended to deliver returns that are in line with nominal GDP growth plus dividend yield. Over shorter time periods, they might become volatile due to uncertainty about long term expectations.
Today valuations are much higher than historical averages. Are you comfortable with that?
When one talks generally about valuation and averages, I assume it is about price to earnings multiples. They are currently in their low-to-mid 20s, which is at the high end of the historical range. Can one conclude from this that markets are overvalued? We don’t think so. Valuations have to be viewed in relative context and the ultimate benchmark is US long bond rates. You can’t ignore the fact that the bond rates are at 100-year lows. In 1980, US long bond rate (10-year) was in mid-teens and even in mid-90s it was around 7%. Today it is 1.25%. If you were to invert the yield to think in terms of multiples, it means that the bond multiple was around 14x in 1995, when S&P 500 equity multiple was in mid-teens. to 80x today. Today the US long bond multiple is 80x, and the S&P 500 market multiple is around 22x. I am not suggesting that equity multiples should be anywhere as high as the bonds, but just putting relative multiples in context.
There are fears that inflation is going up globally and it could puncture the stock rally?
From the market’s perspective what is relevant is long term inflation expectations rather than near term actual inflation. One can consider commodities and wages as the two legs of inflation. Technological advances that have been underway over the last four decades have weakened both these legs. Let’s take fossil fuels such as oil and coal which are the largest of the commodity basket. Technological advances have already led to commercial viability of shale oil, and are enabling gradual transition to hybrid and electric vehicles. In the long term these could lead to abundance of supply amidst declining demand.
Solar power is becoming ever more competitive against thermal power. In the not so distant future, you might have solar powered batteries driving a large proportion of vehicles and other machines that today derive energy from fossil fuels. With alternative food chains on the horizon, it is hard to expect much inflation for fossil fuels.
In the case of wage inflation, the biggest worry is destruction of jobs due to technological advances. So technological advances can be wage deflationary as well. Thus the two legs of inflation are substantially weakened and inflation expectations are dying around the world. In our view, the technology driven demise of long term inflation expectations is the reason for interest rates coming down rather than Fed pumping money.
What themes are you betting on?
We believe money is made in stock selection rather than betting on sectors or themes. The latter is merely a source of macro risk that ought to be properly managed. We keep a balanced portfolio to neutralise such risk relative to the market. Having said that, from a stock selection perspective, at this time, our team finds a lot of opportunities in private sector financials, IT services, consumer discretionary, chemicals and healthcare. On the other hand, they hardly find any opportunities in energy, utilities, telecom and real estate.
After doubling money in the last one year, going ahead what returns can an investor expect ?
At any point in time, the most reasonable ex-ante expectation for market returns going forward is the long term nominal GDP growth rate plus the dividend yield. If you assume mid single digit real GDP growth and a similar level of GDP deflator (inflation proxy) going forward, then adding the dividend yield of 1% gives us about 11% as a reasonable base case return expectation to have from the Indian equity market. This annualised expectation is reasonable for the next 12 months or any other time frame looking ahead, regardless of what the returns have been over the recent past.
Are you comfortable with the way small caps have rallied?
While we do not have top down views, if there is a segment of the market that seems overheated, then at the risk of generalisation it is the micro caps and certain areas of small caps and particularly so for companies with questionable governance standards. Retail investors have been working from home, have had extra time and people who had nothing to do with the market got interested and have jumped in. Such retail money tends to go into smallcaps. Even more so, they go to microcaps which are of subpar quality and volatile. This pocket of market in the small and micro-caps is where there could be risk of excess and caution needs to be exercised there.
