Vivek Kaul – Vivek Kaul’s Diary (India) –
“This time is different,” is an argument that is often heard whenever an asset class is selling at peak valuations. And this is the argument that is now being made when the Indian stock market is at extremely high valuations.
Take the case of the Nifty, an index of 50 stocks listed on the National Stock Exchange. As of November 27, 2017, the index had a price to earnings ratio of 26.61. In simple English, this basically means that an investor is right now ready to pay Rs 26.61 as a price for Rs 1 of earnings for the stocks that comprise the Nifty.
The last time the stock market saw a similar price to earnings ratio was in December 2007 and January 2008, when it was at its peak, and after which it crashed. The only time the stock market has sold at a higher valuation than now is February 2000, when the price to earnings ratio of the Nifty was 27.12. This was when what came to be known as the Ketan Parekh scam was at its peak.
Let’s take a look at Figure 1, which plots the price to earnings ratio of the Nifty stocks, over the last one year.
What does Figure 1 tell us? It tells us that the price of the stocks that comprise the Nifty has gone up much faster than their earnings. This basically means that what the stock market junta likes to call valuations, are in high territory.
This, is not to say, that the stock market is ready to crash now. That is something, which, as always remains difficult to predict. As John Maynard Keynes, who had a quote for almost every occasion, said: “Markets can remain irrational longer than you can remain solvent”.
But what can be said for sure is that markets are clearly in bubbly territory. Given the earnings per share of stocks, their current prices cannot be justified. Let’s look at more data in Table 1.
Table 1: Aggregate performance (all companies)
Table 1 basically gives the details of the growth in sales and profits for 1,241 companies, for the period July to September 2017, the last period of three months for which financial results are currently available. The sales of these companies went up 7 per cent during the quarter, against 10 per cent during the same period last year. The profits were down 1.5 per cent, against the 7 per cent increase during the same period last year.
Let’s now take a look at Table 2, which excludes banks, information technology companies, oil and refinery companies and finance companies. This includes 920 companies.
Table 2: Industry performance – Excluding banks, IT, oil & refineries and Finance (%)
In this case the profits are down 4.4 per cent. The sales are up by only 4.7 per cent. In fact, the situation becomes even more tricky when we look at companies with quarterly sales of greater than Rs 1,000 crore and which form over 70 per cent of the sales. In this case, the net profit fell by 7.4 per cent between July to September 2017. It had risen by 10.9 per cent between July to September 2016.
The current leg of the stock market rally started post demonetisation. The Nifty has returned 25.4 per cent between November 7, 2016 and November 27, 2017. This is a humongous return for a period of a little over one year.
Take a look at Figure 2, which basically plots the Nifty index values over the last two years.
Figure 2 clearly shows that the current stock market rally started after demonetisation was announced by prime minister Narendra Modi on November 8, 2017.
This is precisely why the stock market investors love demonetisation. I recently spoke at an investor conference and some of the reasons I heard in defence of demonetisation were hilarious (we will leave that for another day). In fact, one gentleman, explained his theory on demonetisation to me, and when I took a moment to react, he just turned around and walked away.
As Jean Tirole writes in Economics for the Common Good: “The way we form and revise our beliefs serves to confirm the image we want to have, both of ourselves and of the world around us.” It seems that this gentleman along with many others who I happened to meet had paid a bomb to basically get a reconfirmation of things that they already believed in from the speakers at the conference, rather than listen to new ideas. But as I said earlier, we will leave that for another day.
Now getting back to the topic at hand. One of the stories that has been sold in favour of stock market investing over the last one year, goes somewhat like this. Demonetisation has hurt the informal part of the economy very badly. This means that the formal firms (with many of them listed on the stock market) will take over the informal economy and thus grow in size. This will obviously mean higher profits than before, and which is why you should invest in stocks. The data clearly shows nothing like that has happened. But the story is still going strong and is at the heart of the “this time is different” argument that is being currently made.
In fact, the fund managers, whose compensation actually depends on how well the stock market does, are the heart of keeping this story alive. The trouble is what is in their interest is not in the interest of the investors at large. The incentives are misaligned. And honestly, rare is a fund manager who has used high valuation as a reason not to take in more money in the fund that he manages. In that sense, demonetisation, like quantitative easing that happened in Western countries in 2008-2009 has helped the rich, given that it is the rich in India, like everywhere else, who invest in the stock market. Quantitative easing essentially refers to steps that central banks took by printing money and pumping that into the financial system to drive down interest rates, in the hope of getting both people and companies to spend more. While that may have been the idea, a lot of this money found its way into financial speculation all across the world.
As Stephen D King writes in Grave New World-The End of Globalization, The Return of History: “[The rich] proved to be major beneficiaries of quantitative easing… The S&P 500 index peaked before the global financial crisis of 1,557. It then plummeted to a low of 683. A handful of years later – partly a response to the sustained pump-priming from the Federal Reserve – the index had jumped to a new high of 2,270. Given that around 90 per cent of the total value of financial assets in the US is owned by the top 10 per cent of households, this was – particularly for the very well-off, a very pleasant windfall gain.”
Something similar happened in India in the aftermath of demonetisation as well. Banks interest rates fell dramatically forcing many people to divert their savings into the stock market. Over and above that, many trade businesses which largely ran on cash, were destroyed. A lot of this capital has also found its way into the stock market.
And given this, not surprisingly, the stock market rallied. The rally brought in more investors and the stocks rallied even more. Hence, it is not surprising, that the rich who had money invested in the stock market, remain one of the biggest supporters of demonetisation. They are the ones who benefitted the most from it. And how can something from which you have made money, possibly be a bad thing?