Sensex @ 50,000. Decoding past, present, and future trends.

Life comes full circle outside the Bombay Stock exchange today.

Our memory of January 21 actually signifies a generation gap perfectly. For veterans, January 21, 2008, was the “Black Monday” when the markets fell and the 2008 crisis began. Millennials will remember it as a day when the Sensex crossed 50,000.

The pomp and cake cutting outside the BSE today not only showcase the sheer optimism but also the remarkable resilience and the massive potential the Indian economy holds. A lot has changed over the years and yet a lot remains the same. A deep dive into a few structural factors that have led us to where we are and have set us up for where we are going;

1 – Quantitative easing at a massive scale.

January 21 actually has much more significance than one thinks. It turned the world of economics upside down. One fancy word – Quantitative easing and the markets would never be the same again.

Post-2008, the FED – the world’s biggest Central bank in order to combat the financial distress started injecting liquidity into the financial system. The term came to be known as Quantitative easing – A monetary policy where the central bank purchases large scale govt bonds and other financial assets to inject liquidity into the system.

In simple words, an injection of money does two things to the economy;

1. It reduces the cost of capital so that marginal risk/reward investments become really attractive ie stock markets in particular.

 2. It reduces credit costs which leads to increased lending leading leading to increased spending and a resultant economic boom.

From a purely stock perspective, when interest rates go down – the value of future cash flow increases massively making stocks actually more valuable. QE was actually supposed to be a short term phenomenon. A cushion against the ’08 financial crisis. It however lasted 6 whole years and what’s interesting is the correlation between Quantitative easing and stock market returns.

The above graph shows evidence of a hypothesis that has long been debated. As and when Central banks have injected liquidity into the financial system, it has found its way into the global markets. What started off as a one-off unconventional measure to give a boost to the economy could never be retracted fully.

Ironically, QE itself has come full circle. In order to combat the Covid crisis, central banks had to resort to the ties, and tested measures of QE. 15 trillion $ of stimulus have been put into effect globally. It makes the 2008 number look rather puny. What’s worse is that this time it is a dangerous cocktail of direct money handouts, billions of dollars of corporate bond buybacks, and a few central banks like the Japanese even started buying Equity ETFs! As a result, what you’re seeing is literally a world on steroids. Since bonds especially in the west have negative interest rates, trillions of dollars have had no choice but to flow into equities.

2 –  The Big debate between the divergence in the economy and the Stock market

When the Nifty touched its previous high of 12400 again a few months ago, the big debate was how fake the rally is and the fact that the economy is in a shamble so how precisely can the market rally? This is anchoring Bias at its best. Most of us were so overwhelmed by the fact that the market bounced back so ferociously in the near term, we fail to critically analyze historical data points;

• Globally, both in developed and emerging markets – the markets usually compound at a 20% – 25% premium to the Nominal GDP growth rate.

• If you do the math on the stock market returns between the 2008 high and the Nifty@ 12,000 – You get a CAGR of 8%. Nominal GDP on the other hand has been 11%.

• What has Really happened is that the market returns for the LONGEST time were lagging the returns of the Nominal GDP.

• The reasons for this arguably are many  – taper tantrum in 2012/13 , sub par corporate growth rates , lack of FPI participation as developed countries were doing very well.

• If you do the math and calculate the Growth rate of Nifty at even 11% which is equal to the nominal GDP growth rate, you would get a figure of  ~ 15,000 on the Nifty, exactly where we are heading right now.

There is one divergence through – A massive difference between the Nifty and the Midcap/Small Cap Index. A central theme of polarization has emerged in the Indian markets. 70% of all the corporate profits are produced by only 20 companies in India – The result? – Stock market returns are getting skewed. You would make much better returns holding a concentrated portfolio than holding the index or a Mutual fund.

The message is simple – the Big is getting bigger in India and SMEs have not been able to grow. The Mid/Small-cap stocks are expected to play catch up but when is anybody’s guess.

3 – When will the economy bounce back – Well, the worst is behind us.

The Indian economy started seeing major headwinds post demonetization. The sheer shock of sucking cash out of a system and effectively having a parallel economy come to a grinding halt leading to significant degrowth. While most people pointlessly debate the politics of the situation, what really transpired due to both DeMo and GST was a massive shift towards an Organized way of doing business.

From an exchequers point of view, this means more people coming into the tax net and more revenue, and a better fiscal situation. Monthly GST collections along with the PMI index are some of the best ways to gauge the health of the Indian economy. Just before Covid struck, there were in fact a lot of green shoots in the economy before Covid struck. While the pandemic was thought to be a big dampener, what is remarkable is the recovery that we have seen on the economic front in the last few months.

Most high frequency indicators including the PMI index and GST collections which are back to 1 lakh cr/ month indicate a recovery much faster than many of our peers in Emerging markets.

4 – Valuations – One of the biggest misunderstandings is the PE ratio. A lot of skeptics would tell you that the Nifty at a PE of 35 is grossly expensive. That’s not a right way to look at things in the first place. The PE ratio of 35 is a trailing measure. It looks at the 12 months that have gone by. Since earnings were hit, the denominator was hit and the PE ratio becomes artificially high.

The better metric is a Forward PE ratio and the CAPE ratio which at current levels indicate that the market is pricing in a fast recovery to normal. Sure the Nifty is expensive but if growth catches up in the year ahead, we would be looking at a much better 2021.

5 – What’s next for the Indian Markets?

Never waste a good crisis they say. Beneath the current negative undercurrents, a lot of potential positives have been shaping up in our periphery. A lot of indicators are telling one story – Emerging markets , especially india are getting set up for a fantastic decade. We discuss a few here;

Interest Rates – The FED has already indicated that it will keep benchmark rates near ZERO till 2023. The enormous implications of this are hard to put in words.

Very simply, for the best part of 3/5 years, Treasury bonds are going to yield next to nothing in the developed world. So why would funds that typically have a large fixed income exposure, be invested there for negligible gains? – This tsunami of money has already started rotating into equities. One must also understand that the developed countries have trillions of dollars in liabilities that are due in the next decade or so in terms of pensions or money needed to support Social Security. All of this money is managed by pension funds which is currently hunting for asset classes that offer a good yield.

A weaker dollar – Trillions of dollars printed in the last few months. 20% of all the currency ever printed by the USA since its independence was printed in the last 180 days. Now its simple economics – When supply overwhelms demand – You get an asset bubble. A lot of money ends up chasing anything and everything that it can get its hands into. Exactly what’s happening in the stock market. And expect this to continue as the Central banks will continue to pump in money for the foreseeable future.

A weaker dollar also helps Emerging markets like India massively as everything that’s imported becomes cheap, right from crude oil to all Raw materials. USDINR going from 76 to 73 could look like a small move but it translates into billions of Dollars of savings which get injected into the economy.

The CHINA + 1 strategy –  A potential gamechanger. There is no way to quantify this now but if Covid taught the world something it is to keep your options open. There is an imminent possibility of a significant shift of Supply Chains in the next few years from China especially in the Pharmaceutical/ Chemical and Auto space. Taking Specialty Chemicals as an example, even if 5% of the markets shift to India( which has already been happening in the last few years) – that is a 20 billion$ opportunity right there. This will not only translate to a much vibrant economy but will have a multiplier effect on the stock markets. Any substantial uptick of FDI in India will be a big positive for FPI money.

Government policies –  Anybody can think about reforms, execution is what matters. There has been great progress in terms of reforms but a lot yet has to be done. The big positive here is disinvestment. I’m a big believer that the govt has no business being in business. As the govt will try to pump in more money to get the economy in better shape, there will be a big push to disinvest. This bodes well both for the private sector and the markets in general.

Some exciting on the anvil is the PLI scheme – The PLI scheme across these 10 key specific sectors will make Indian manufacturers globally competitive, attract investment in the areas of core competency and cutting-edge technology, ensure efficiencies, create economies of scale, enhance exports, and make India an integral part of the global supply chain. There are exciting times for India ahead both as an economy and as a financial market.

Bright economic prospects vis a vis its peers, Expected benefits due to an impending shift from China and massive liquidity flowing around the world have literally set us up for a perfect decade.

Source: www.seekingalpha.com & www.bloomberg.com