Very recently, RBI created flutter among investors by stating in its annual report that there are reasons to worry about stock market valuations in India. According to the ace bank, the current valuation is almost in a bubble territory. As per RBI, the stock market is richly valued and is way ahead of the current state of economy. The primary reason for such high valuation is excess global liquidity and excess greed of investors. Such warning signs by highly respected central bank of India should be seriously taken. But, there is no reason to press the panic button yet. The current market situation is no less than a complex puzzle that every investor is trying to solve in one’s own way. This article shall give you clues to solve it in a more informed way.
It is not the first time when RBI has warned of stock market bubble. A few months back also RBI had issued similar warning. If we compare Nifty 50 & Sensex at current Price to Earning (P/E) ratio, which is 30x, the valuation is higher than 2008 Sub prime bubble (28x) and 2000 Dot Com bubble (27x). However, the current high valuation is due to sudden sharp dip in corporate earnings due to COVID related lockdown last year. If we account for recovery in earnings in the current year, this P/E ratio should fall in the range of 20x to 23x. Secondly, During 2000 and 2008, interest rates were relatively higher than in 2021. Hence, the P/E ratio when seen in light of low interest rates, is not overvalued.
Another aspect to be considered right now is that the corporate earnings cycle is on the anvil of recovering very sharply. Had it not been due to COVID 2.0, there would had been good deal enthusiasm around that. Investors would know that Corporate Earnings to GDP ratio is currently trending at around 1.7%. During the 2008 peak, this ratio was around 7%, and in 2000, the figure was 4.2%. Due to recent disruptions like demonetization, abrupt GST implementation, and then followed by COVID lock downs, the corporate earnings have been battered to death. But, the lockdowns have proven to be a boon to many corporates as they could boost their profitability by cutting down the costs faster than their sales. The current PAT margins are at multi year high. Now when the recovery will take place, the higher profit margins shall provide bumper corporate results. There is ample room for Corporate Earnings to grow faster than the GDP, and take the Corp. Earning to GDP ratio back to median range of 3.5x, or more.
Another positive factor that can actually work towards keeping the equity momentum going is that households around the world are sitting in surplus savings. Due to lockdowns, people have not spent on travel, lifestyle items, etc. As vaccination coverage improves, the consumption too shall rise, adding higher profits.
In equities, we cannot talk of opportunities without discussing threats. Also, we should know that if any particular threat was to actually take place, what degree of damage it can cause. There are two big possible risks that can cause panic in the market. Firstly, there is huge complacency among investors that interest rates are going to remain low for very long time. The underlying assumption is that since the world economy has not fully recovered from Covid shock, central banks around the world will keep the interest rates artificially low, despite sharp rise in inflation outlook. The negative real interest rate will keep investors flocking to risky investments like Bitcoin and stocks. Investors need to be cautious here. Already we have seen a few Central Banks (Brazil, Russia, New Zealand) having raised the interest rates. Canadian central bank has started sucking out excess liquidity from the system. At some point in time, even US central bank would also be forced to adopt taper tantrum.
Second risk is resurgence of COVID around the world. Any complacency about it can be lethal. We have already witnessed Indian episode over last 2 months. Latest variants of British and Indian origin are being found in many countries across the world. These variants are multi times contagious than the original. The developed world will act rapidly on vaccination. However, middle income and lower income countries will take 2 to 3 years to vaccinate their population completely. It is important to understand, that the world will not be a normal place, as long as there is even one person testing positive for COVID. There is an uphill task ahead for governments. Until then, lockdowns in one part or the other can keep happening around the world, thus impacting economic recovery. Since covid virus multiplies and mutates very fast, one cannot deny newer variants continue to emerge. If there happens to be a mutant that is immune to vaccine, it can really shake things up!. The probability of such a mutant is very very low, but cannot be denied.
Investors should be careful in chasing the momentum. They should invest with due diligence in stocks that are available at intrinsic value and are supported by good business model and governance. So many new investors have entered the markets over last 1 year. They are sitting on more than expected profits. Higher profit in the portfolio makes investors gullible to market narratives. It is not fair to assume that they would show any maturity towards hidden risks, as majority of them would not have seen any major crash in their investing career. Still, it is best advised that there is no need to panic, but watch out for landmines. If any of the threat plays out, there can be a correction to the tune of 15% to 20%. But, don’t get surprised by the volatility. Stay in the market for next 3 to 5 years. The markets should reward you well for patience. Stay safe and follow COVID protocols