Worldwide stock prices and the underlying fundamentals of the stocks have never been as disconnected as they are today.
Certain large companies have crossed $1 trillion in valuations in the American markets. The term centibillionaire (someone who has a net worth of $100 billion) has become common usage in the pink press.
The main reason for such euphoria has been the infusion of huge amounts of liquidity into global markets by all central banks, including our own Reserve Bank of India. The developed world has borrowed heavily and been very generous in giving stimulus to businesses so that the fall in economic activity can be cushioned.
India remains the only large nation which has not given a substantial direct stimulus.
The conventional wisdom was this money would make its way through the economy and reach those who deserved it, such as small and medium enterprises. However, despite the huge liquidity, banks in India and globally have become risk-averse and are not making fresh loans.
Bond EFT purchases
The Federal Reserve, in an unconventional action, has been buying bond ETFs and at times, junk bond ETFs to prop up the credit markets. Thus, it was natural for the excess money to cross the ocean and reach Indian shores.
The money has been chasing quality Indian stocks and this has created a narrow top in the Indian equities markets. Price action in a handful of stocks is driving the value of the index.
More than 60% of investments in India have been in one company which is primarily a provider of telecom services. The market would like to believe that it has reincarnated as the next tech wonder. The same company is now selling a minority stake in its retail business for astronomical valuations.
A handful of private sector banks have raised equity capital to offset a probable rise in non-performing assets. At the end of trading hours on October 16, the price to earnings ratio of the Nifty was 34.13 times its trailing 12 months earnings. The normal valuation should be around 15 to 18 times earnings. The current EPS of the Nifty is in between 348 and 350.
If one were to look at the index returns for the last three years, the return on investment has been very poor and nothing to write home about. The one-year return was 3.76%, 2-year return was 13.96% and the 3-year-return 16.4%*.
This is the reason why, after a big rally from the lows of March, retail investors are continuously pulling money out of the Indian stock markets.
As data from AMFI has shown us, there are two ways that a stock price can rise: a continuous increase in the earnings of the company and its subsidiaries; an expansion in the price-earnings ratio of the stock.
The latter means that the new investor is willing to pay a higher price for stocks whose earnings have not increased.
This is largely due to the triple whammy of demonetisation, a faulty GST and finally a global pandemic. Let us assume the worst is behind us and corporate earnings will bounce back. A 30% increase in profit will translate to an EPS of 450. Even then, the price-earnings multiple will be almost 28 times earnings and will have no upside left for investors to benefit from.
With any meaningful appreciation of stocks thus ruled out, any global event can send the price of equities tumbling down. The truth is, we do not know when the pandemic will end or a vaccine will be ready.
Hence, a sharp rebound in profits of index stocks is an unlikely event. I have mentioned a narrow top. Here is the evidence.**
1. Reliance Industries 14.9%
2. Infosys 7.62%
3. TCS 5.4%
4. HDFC Bank 9.67%
That is, these four stocks above have contributed to a weight of 37.6% of the index.
1. Hindustan Unilever 3.81%
2. HDFC 6.43%
3. ICICI 5.05%
If you add 3 more stocks totalling to 15.3%, the contribution of the 7 stocks crosses 50% of the weight of the index.
The balance 43 stocks contribute the remaining. This is why no active fund manager has been able to beat the Nifty thanks to the SEBI ruling which does not allow the fund manager to invest 10% in a single stock. The feeling in the market that it is less risky to invest today is erroneous.
As American investor Howard Marks has pointed out, the higher the price levels, the greater the risk.
There seems to be a mob psychology of fear of missing out on a good thing.
People should like something less when its price rises, but in investing they often like it more, he had said.
This is primarily driven by envy and greed when one believes his neighbour or colleague has made quick money while he himself has missed out. One should remember that the legendary Sir Isaac Newton lost his fortune in the South Sea bubble and said: I can calculate the motions of heavenly bodies but not the madness of the people.
If at all one has to take exposure to equity, it is better to buy passive index funds and increase allocations as the market corrects but one must again remember Mr. Marks quotation, Investment success doesnt come from buying good things, but rather from buying things well.
**NSE indices, 2020
(The author is a financial consultant and can be reached at firstname.lastname@example.org)