During this pandemic-triggered global recession characterized by profound uncertainty, investors have to be cautious.
VK Vijayakumar
"There is so much liquidity in the system, in the global economy, that's why the stock market is very buoyant and it is definitely disconnected with the real economy. There will definitely be a correction but we can't say when," RBI Governor Shaktikanta Das stated on August 22, 2020.
Central bank chiefs are right in warning about market excesses. When bubbles created by exuberance burst, they create multiple impacts on financial markets leading to financial instability with profound consequences for the real economy. The problem, however, is that it is difficult to judge what is fair valuation and over-valuation.
During the tech boom in the US, the legendary Federal Reserve chief Alan Greenspan warned of "irrational exuberance" in the market. Greenspan gave the warning about a looming asset bubble in the US in a 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 December 5, 1996.
Greenspan said, “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?
In spite of this warning by one of the shrewdest and knowledgeable 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.
So, the relevant questions in India now are: How serious is the disconnect between the real economy and markets? Are valuations excessive? What should be the ideal investment strategy in these challenging times?
At all levels of market valuations, there would be optimists and pessimists. At excessive valuations, while some would sound the alarm and predict that the bubble would burst, others would come out with new theoretical justifications for the high valuations. The tech and the housing bubbles, which crashed in 2000 and 2008 respectively, had some smart theories to support their lofty valuations. The reverse also is true. Even when stocks become cheap and valuations turn attractive, there will be sceptics warning investors of a further crash in the market. Whether the optimism and pessimism were justified will be known only with the passage of time. As Warren Buffet famously said, "You discover who has been swimming naked when the tide runs out."
There are various parameters for judging the market valuations: PE ratio, Market cap to GDP, Price to book value and Dividend yield are widely used. The most popular is the PE Ratio. Some gurus like Warren Buffet emphasize Market cap to GDP. Going by the PE multiple, globally markets are overvalued. Nifty at 11,400 is trading at above 25 times FY20 earnings, which is hard to justify from the earnings perspective.
Of course, valuations in India are justifiable from the Price to Book and Market cap to GDP ratios. Presently, the Price to Book ratio is around 2.5 and Market cap to GDP is at 0.76, both lower than last 10-year averages. But it is important to appreciate the fact that in the mother market US, Market cap to GDP is excessive at 170 percent. On previous occasions when this ratio became excessive like in 2000 and 2008, markets crashed leading to a global rout.
During this pandemic-triggered global recession characterized by profound uncertainty, investors have to be cautious. The sharp spurt in Nifty by around 50 percent from the March lows has given big profits to investors who stayed the course and bigger profits to those who invested during the crisis. The ideal investment strategy now would be to: remain invested in top quality stocks; avoid penny stocks; continue with SIPs; invest in mid-small-caps through mutual funds and, importantly, increase the cash component in portfolios.
The author is Chief Investment Strategist at Geojit Financial Services.
Disclaimer: The views and investment tips expressed by investment expert on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.