“When the facts change, I change my mind. What do you do, sir?” – John Maynard Keynes

The vaccine vengeance reflected in the Indian markets with Nifty moving +11.2% in Nov so far and Nifty Midcap 100 by +15.2%. To put this rally in context; Over the long term mean annual returns for the indices are probably in the similar range so you got a year worth of returns in a month (or missed it). If you compare these with the current dismal returns offered by the Debt instruments/ Fixed deposits 15% in a month is 3x to the annual FD returns of 5% in Large commercial banks. Such a large move in the month, when uncertainty around COVID is still prevalent, can trigger the various emotions regarding your portfolio decisions in this year.

Regret that you missed the opportunity to invest in March 2020, Greed to pump in more money in the current market run up to get some more returns, Fear that markets have been hitting all time highs and let’s redeem, Triumph that you killed that market by investing in march and now sitting on handsome gains or many more…

The best way to counter such dissonance is to rely on the facts and analyzing the facts. I have mentioned in one of the earlier articles why being rational pays off, may be its time to remind about the same. There are three main pointers floating around at present as below; we would analyze the all three in details.

  1. Earnings
  2. Valuations
  3. Liquidity

Earning growth in 2Q2021 (Jul-Sep 2020) has been drummed as a fantastic rebound of the earnings cycle and it has been used to paint a pretty picture of current markets after all market returns are highly correlated with the earnings. If I look at the standalone profits after tax for Nifty 50 companies in 2Q2021 INR 97,000 Cr, the earnings have grown by whopping 96%+ vs 1Q2021 and +39% vs 2Q2020. Now this standalone fact is pretty good to convince anyone about the earnings growth story. But If you decide to drill down this fact then the point worth remembering is that “In 2Q2020, we had the historic losses posted by Bharti Airtel (Loss of INR 24,500 Cr) after the court ruling. If we remove Bharti Airtel and compare the earnings of remaining 49 companies, we would have had the growth of mere 3.1% on YoY basis.” I am sure, I do not have to remind about the reason for lower earnings in last quarter given the lockdowns.

Nifty TRI/ Nifty PE Since Jan 2014 to Nov 27, 2020

If we look at the earnings trend Since Jan 2014, you would notice the flattish nature of the earnings so far. In last 6 years the CAGR for earnings have been <3% so should we expect the large earnings growth here onwards? Below is what I think:
1. Corporates definitely took the opportunity to cut the dead weights. They have cut down on the expenses and the Margins have improved. This should be long term positive
2. With the roaring market, lot of companies have raised the fresh capital and pared down the debts. The balance sheets have been stronger, which again is a long term positive
3. The banks would have been unscathed so far on NPA front given the moratorium and then the recognition as NPA needs 3 months of default so it might materialize only from the next earnings season. If we go by the RBI expectation of growth in NPAs then projection is bad. Banking is still the biggest sector in Index, hence this has potential to drag the earnings down

In summary, If I have to project the next 4 quarters of earning cycle then probably you might see some growth because we would have poor quarters to compare. Question is “Will the earnings growth be enough to push the markets further up”.

Valuations are sky high; This is the second narrative. The current Nifty PE is 35.66, which is one of the highest in last 20 years history. This as a fact is quite worrisome to cause the fear for investing. If I can borrow the below table from one of the earlier articles (Is index PE relevant), you can see that higher the PE levels the mean value of future returns keep decreasing. Let me also supplement this with the Valuation Index data from my workings as well, which also says the same that increasing valuations = lower mean returns.

Though we need to understand it bit better, the relation of valuations with returns is not extremely strong. From the VI Value table, you can see at in each Valuation Index range the Min & max returns have a dispersion of 100+ percentage points (For VI 6-7, Min -15.6% and Max 95.6%, the difference of 111.2%). Therefore, thinking only in terms of mean returns is not very wise. The only conclusion I would draw is that “higher the valuations, higher the chance of getting negative returns”. Therefore, the higher valuation levels should warn us but not demand to be 100% out of equity markets.

Liquidity is ample; This is the third narrative that the markets are flooded with extra cash and people are taking more risk given the risk-free rate is hitting all time low of 3-3.5%. This could be easily illustrated by the fact that AAA rating Corporates like NTPC are able to issue the commercial papers at <3%. The YTM for most Money market funds/ liquid funds is 3-4% in most cases. Banks have the optionality to keep the money back with RBI at 3.35% but Mutual funds do not. Let’s analyze the liquidity impact in two terms, first to understand if drives the market returns and second how sustainable will be the situation of excess liquidity.

In an earlier article, I did flag that valuations expand when the interest rate decreases (Importance of PE ratio). To put this theory in practice I analyzed the last 15 years data and compared the Nifty 50 TRI returns vs Valuation Index & 1yr Forward rate on T-bills, adding the T bills in regression improved the R2 of the regression [Ask for the file, if interested]. This ascertained that rates do play a part in projecting the future returns. Now, It’s important to understand the sustainability of the low rates. We are in the rare economic conundrum when the inflation is rampant/ increasing and GDP growth is negative; one needs the rate to go higher, while the other demands the opposite action. Rates might bottom out here with max 1 small cut or no change in next 1 yr but RBI would continue to use the non-traditional measures like OMO to keep the liquidity going. The market returns should not have any major impact of rates in next 12 months.

I can not predict the future but after analyzing these narratives, I am more inclined to suggest to be underweight on the equity as asset class. If your ideal Asset allocation to equity is 50%, you would be probably more prudent to keep only 30% allocation in current period. Remember that “To protect your downside, you need to let go some upside” as well as “To win the race, you need to run/ participate”. Lastly, if you are still not convinced about why you should be content and ignore the rally then read this statement of Jeffery Gundlbach “I turned negative on Nasdaq on Sep 30 1999, I was really negative. Of course, in the 4th quarter on 1999, it went up by 80%. But one year later, it was down 50% from the Sep 30th level.”

Let me know, your feedback/ suggestions. Till next time, Happy Investing!