Investors believe stocks are overvalued but disagree on how to play the market
Since the nationwide lockdown announced by the Prime Minister in March last year, the Indian economy has faced its worst contraction in history. Yet, the country’s stock indices, the Sensex and the Nifty, have almost doubled in price from the low that they hit in April 2020. Many analysts and even the Reserve Bank of India now believe that stocks are in a bubble. In this conversation moderated by Prashanth Perumal J., Anand Srinivasan and Alok Jain discuss the current state of Indian markets. Edited excerpts:
Can you shed light on the divergence between the stock market and the real economy?
Anand Srinivasan: The markets are going up on liquidity. Basically, all central banks are printing money and this money has to go somewhere. So, what we are having is asset price inflation. The prices of gold, crypto assets, stocks, and even collectibles have increased dramatically. While we may look at the Indian market in isolation, we have to understand that this is not the only market that is going up. All equity markets are going up. When you see year-to-date comparisons, India is not in the top five countries whose exchanges have done well. There is a lot of money chasing very few stocks which are of high quality. Nearly 45% of the index is controlled by five stocks. The Nifty is trading at around 29 times its earnings and its price-to-book ratio is at 4:23. So, the markets are indeed highly overvalued.
Also, Nifty earnings per share is at ₹559, and ₹100 of this can be attributed to tax sops to corporations. These have driven prices of these companies up further. But the reality of the rest of India is different. India and the rest of the world are going through a K-shaped recovery where the rich are accumulating a larger share of resources from the rest.
Do current valuations worry you or even matter to you?
Alok Jain: We don’t look at valuations because our focus is on price trends. We follow the principle of “Bhav Bhagwan Che (Price is God)”. We believe that price incorporates all the information that is required to be incorporated into a stock. However, as Anand said, it’s a liquidity-driven rally. It is always a liquidity-driven rally. We tend to equate the real economy with the stock market at all times, but they hardly ever meet. That is the sole reason 90% of all economists and analysts in the market are not able to call what’s going to happen next. Traditional valuation models are getting broken because the whole money supply equation is changing. If Japan can trade at 34 times earnings, the U.S. at 28 times earnings, and China at 19 times earnings, Nifty could trade at 40 or 30 or 20. You take your pick and you can justify it there. Coming back to liquidity, the Fed has pumped about $5 trillion or so and so have other central bankers. We are sitting in a vulnerable situation across markets. So, there is no real model that you can rely upon for investing when there’s endless money flowing around. One should ride the trend till the end and not sit out of the market.
Anand Srinivasan: Alok says everything is about liquidity. I will pick up two cases from history. Let’s talk about 1989 when the Nikkei peaked at 40,000. Now, 31 years later, the Nikkei is nowhere near 40,000. It is still about 30% below its peak. The Dow Jones in 1929 crashed from 800 to double digits. It took the index 25 years to recover this loss. So, this party has to come to an end sometime. We don’t know when exactly but the early warning signs are there. American inflation is running at 4% for the first time in many years and Indian inflation has been consistently higher than what the RBI projected 10 out of the last 12 months. Some say this inflation is transitory. But one year of inflation is not transitory. We have to wait and watch because as inflation begins to bite, that is when politicians will remove the punch bowl and the party will come to an end. I don’t see this happening until early-2022 because U.S. Federal Reserve Chairman Jerome Powell will not want to spoil the party now — his nomination is due.
Alok, what is your technical view on the market while looking at the charts?
Alok Jain: From our perspective, nothing much has changed. The way we work is that we have long-term models which measure momentum and we then allocate across stocks. So far, we have not seen our models go to cash. As the market plateaus or starts to go down, our models tend to go into cash gradually and that has not yet started to happen so there is no concern right now about the uptrend. Over the last month or so, the markets have kind of stagnated. But there is enough opportunity and activity within the mid-cap and small cap space. So, nothing really has changed. There may be an episode of profit booking but that would be a very normal reaction. The fear actually is that any market could become the next Japan where the market spends years consolidating so that valuations can catch up with price. This could be just like what we’ve seen in the real estate market. In case liquidity keeps gushing through, we could be at 18,000 on the Nifty and the resulting pain could be deeper and longer. So, we need to be ready with a plan to exit the market.
Anand Srinivasan: If I look at any of the big names who have made money over the last 150 years, they didn’t make money by riding the market. They made money only by staying invested and finding quality companies at good prices. Liquidity in the markets will come and go. From the late 1990s to today, America has been under the influence of steroids injected by the U.S. Federal Reserve. So we’re looking at a gush of liquidity over 20 years. But the history of markets shows that interest rate cycles do turn. It is hard to predict when the cycle will turn, but it should turn in the next five years. When the interest rate cycle turns, equities will witness a fall. That is the time to accumulate equities. In America, it was between 1969 and 1974 that Warren Buffett made most of his stock purchases. Then, there was the period in 1987 when there was a major crash. In 2002, there was a major crash again. The only difference is that the pullback in stock prices this time has been much faster and more violent, which has not allowed people like Mr. Buffett to buy. But markets still have pockets of values.
Alok, what is your take on the fundamentalist viewpoint on markets?
Alok Jain: There’s nothing wrong in the fundamental view. The only question is, while Mr. Buffett is quoted so many times, how many people can act like Mr. Buffett? You can’t really emulate the qualities of great investors. So, we need to find more common man strategies, so that you can live your life peacefully and also have healthy returns on your money instead of just hoping for positive long-term returns. In Japan, the generation that started earning and investing money from 1990 has not seen any gains so far. How many would survive in that kind of an environment? That can happen to any country. So, just investing based on great names, quality and great fundamentals did not ensure positive returns to Japanese investors. There are very few lucky guys who can really say that they started investing 20 years ago and that they’re sitting with multibaggers. That’s not the average investor’s journey. Our approach to the market is very, very clear. We will not predict where the market is going. Instead, we will allow the market to tell us what to do.
Anand Srinivasan: Since Alok said people have not made money in Japan, let me quote a story. About one and a half years ago, Mr. Buffett decided to buy in Japan. He went to the bank and took a loan of several billion dollars at near-zero interest rate, payable over 25 years, and bought five big companies which had a dividend yield of over 5%. He uses the dividends to pay off the loans and now basically owns a 5% stake in five Japanese business conglomerates free of cost. That is value investing. So, you basically get money free, you put it into a company whose dividend will pay off the loan with low interest, and then you can relax. This is the way it should be. I agree it is very difficult. It takes enormous patience. If people cannot do this, then the alternative is to buy the index for the long term. Just keep buying the index over the next 30-40 years and go to sleep. Put in 50-60% of your money into the index and the balance in bonds and go to sleep and the index will take care of it.
Does investing in the index sound like a sensible strategy to momentum investors?
Alok Jain: Interestingly, if you look at the index, the index itself is a momentum portfolio. Every six months, the index committee will sit around and throw out the laggards from the index, and bring in stocks that are rising. So, the index is actually a beautiful momentum index. You can buy index ETFs (exchange-traded funds) or index funds at a low cost and actually run a momentum strategy. That can be your base momentum strategy. Then you can take premium products and run premium momentum strategies. My short point here is that if the index itself is like a momentum strategy that really validates momentum investing.
Anand Srinivasan: The index in India is a very shallow index. When I say index, I am talking about a broad index like the S&P 500. Unfortunately, we don’t have mutual funds which follow the BSE 500 in a big manner. The best you can do is buy the Nifty and the Nifty Next 50. If you get an index for the Nifty 500, buy the Nifty 500 and go to sleep.
The difference between momentum investing and the Nifty strategy is we keep the Nifty and buy more of it when the index goes down. What makes the difference between following the Nifty strategy and the momentum strategy is that I have to pay a 2% fee to the manager. In the case of the Nifty, I have to pay only 0.05% to the manager. This fee difference makes a big difference over a period of 10 or more years.
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Alok Jain: The S&P 500 is also similar to a momentum portfolio. It is rebalanced four times in a year instead of two times as is the case with the Nifty. And in the last decade, 200 companies have gone out of S&P 500 and 100 new companies have come into the index, so it is a beautiful momentum portfolio. Additionally, there is over 200 years of data showing that momentum as a factor has beaten other factors such as value and growth.
How do you see the markets going forward?
Anand Srinivasan: I see this bubble continuing to play out depending on two things. One is inflationary expectations because inflation expectations will determine when the U.S. Federal Reserve will raise interest rates. If U.S. President Joe Biden allows inflation to run to 7% or 8%, then he may be forced to bring it down, and the Fed will be forced to apply the brakes very quickly. If this episode of inflation turns out to be transitory, the current momentum in stocks will continue for a year or so. It all depends on the inflation trajectory.
Alok Jain: The inflation bogey is upon us, and I don’t foresee inflation dying out. More than inflation, real interest rates need to be watched, because a nominal interest rate rise may also get absorbed in the market. It will take some external event probably for the U.S. Fed to change course. So, the current trend seems par for the course.
Alok Jain is a SEBI-registered investment adviser and a momentum investor at weekendinvesting.com; Anand Srinivasan is a value investor and the author of Ordinary Stocks, Extraordinary Profits