The widening gap between the economy and the stock market

The widening gap between the economy and the stock market

Current Scenario : Stock Market is perceived as a proxy indicator of economic health. The current pandemic has caused severe damage to the entire global economy; having said that the damage is not uniform across the industry – some severely impacted while some will gain from the current crisis. On the other hand, the Government and the Central Banks (read RBI in Indian context) intervention is driving the stock markets up, giving a good shine on the face.

This has led to a lot of confusion in the minds of the investors. The greed factor pushes to stay invested or invest more (i.e.- FOMO: fear of missing out) while the fundamental of investing suggests to be cautious of the widening gap between the economy and the stock market .
Should one invest and ride the momentum or should one start to book profit and play safe?

The Liquidity Exuberance: Across the world, the central bankers (including Reserve Bank of India) have reduced interest rates drastically. Few of the world’s major developed economies are either having very low interest rates or negative interest rates. The money is available cheap. Just because the money is available cheap it is not being used by Industries to expand capacities. Illustrating with an example to convey in a simpler manner; a company has an installed capacity to manufacture say 10,000 Cars a day but the current demand is making the company to manufacture only 6,000 Cars a day. Just because money is available cheap, the company will not set up additional capacity to manufacture more cars.
Thus, the excess money supply or liquidity as it is called remains in the banking system. The banks, financial institutions and the Foreign Financial Institutions invests the money in stock markets.

Why are the Institutional Investors investing when the economy is in the doldrums?

A simple indicator used while investing is Price to Earnings (P/E) Ratio, suppose the trailing PE is 25. The inverse of PE is Earnings to Price (E/P) meaning what can you expect to earn by investing, using the above PE of 25 the E/P will be 1/25 – it means the stock market yield is 4% – {i.e. (1/25) x100}. So, the stock market is yielding 4% return on a borrowed money that is available at almost zero interest rates, hence the institutional investors utilise this arbitrage opportunity and are aggressive investors even at high valuation levels.

The Fundamental Stack: How does the economy stack up in the current context? The current pandemic has caused severe damage across Government, Corporate and Individual Balance Sheets.

The S&P Global estimates that the Global GDP will tank to (-) 3.9% in 2020 from 2.8%; while India is expected to tank to (-) 5% from 4.2%.

The Indian economy even in Pre – Covid era has been struggling with growth. The Indian stock market has only 0.24% correlation to the GDP Growth rate; it has a stronger correlation to the corporate earnings.

Let us evaluate what’s the expectation of Corporate earnings in times to come. Leading research & rating agencies estimate that the FY 20 earnings will come back by FY 22; simply put it means we have lost out two years of corporate earnings to the pandemic. Assuming if that were to be true then the trailing PE, is technically a 2 year forward PE. The current trailing PE stands at 29 times (source: www.nseindia.com)

Few equity investors may ignore PE multiple metrics and use Price to Book Value as a more appropriate benchmark in absence of authentic earnings estimates.

Let’s evaluate how do we stack up against the Price to Book Value metrics. The Price to Book Value multiple from a peak of 3.81 around 15 Jan 2020 fell to a low of 2.17 on 23 Mar 2020.

Please note that the pandemic since March 2020 has gone from bad to worse, yet the Price to Book Value bounced back to the current level of 3.18 (as on 21 July 2020).

When the Price to Book Value was 3.81 and P/E about 29 times around mid-January 2020, we were worried and cautious, but yet the hope for a better tomorrow prevailed. Now, with the pandemic struck economy struggling to limp back I am a little more worried with the widening gap between market valuation and the real corporate earnings.

Conclusion:

The fear of the pandemic started with an aggressive selling across the world, but the central bankers reacted much more swiftly than the earlier times of 2008 and with much greater intensity of relief measures, thereby driving the markets up again, with almost a “V” shaped recovery. Given the excess liquidity it is very difficult to predict to what extent this exuberance will last

Markets are bound to be irrational in the short-term only to align to fundamentals over the long-term period. Hence, wisdom suggests to control what we can and avoid the ones that we cannot.

Whether you are an investor or a financial planner / an investment advisor , it always pays to arrive at the investment decision based on a well-defined set of data points and investment rationale; thereby acting as a true custodian of the investment. It will be prudent to book profit or trim equity exposure at this level to preserve your current assets / portfolio.

By no stretch of imagination, it is suggested to time the equity market. Simply put follow the cardinal rule of following a strategic asset allocation; balance the portfolio based on the asset allocation and your money need.

The final icing – will you love if the equity market moves up by 25% in three years from here (meaning Sensex at 47500 and Nifty at almost 14,000 by 2023)? Given the earnings uncertainty you would simply love it or perhaps jump with joy.

Visualize this, if you trim the equity the downside gets protected and invest in debt. A portfolio asset allocation delivering 8% CAGR over the next three years will deliver 25% absolute gain.

Simplicity creates #wealth

This Post Has 113 Comments

  1. Very nicely articulated. However, for a long term investor ( equities are long term investments) it’s more important to continue investing systematically, in the businesses, having a long history of sustainable and scalable growth. 2-3 quarters of flat growth or degrowth may not matter in the 40 qtr performance..

  2. superb article
    every one needs to be cautious now after reading this article

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  4. Excellent review of the current financial situation. The complicated situation is explained with clarity of thoughts.
    Thanks Tanveer jee
    Dr naresh Madan

    1. Excellent review , enjoyed reading it.
      Thanks

  5. Very well explained. E/P explanation of 4% yield, gives a lot of clarity about about current increase in Index inspite of widespread uncertainty all around

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