Investors must not allow to be fooled by the fantasy of the past.
By IE&M Research
The world politics, UK’s exit from the European Union, rising unemployment and immigration and sluggish global trade impacting GDP growth require government leaders use unconventional monetary and fiscal tools which have not yet shown the promised results.
The stock markets, which abhor uncertainty ought to be very sensitive to these far-reaching changes the world is witnessing and the consequences are going to be borne by the investors. Whether they like it or not.
Indian markets being a sweet-spot for a variety of reasons may deserve to command a premium over other markets. But, it’s already trading at premium to peer valuations and has run up 25 percent since March this year. Amid this out-of-line challenging environment, investor’s craving for outsized gains are likely to be frustrated.
Stocks and bonds investors must brace for lower returns in the coming years, perhaps decades, as the golden era of super returns seems over. The factors and forces that drove exceptional investment returns to investors on the street over the past thirty years (1985-2014) are weakening, and even reversing.
The new analytical framework must link the investment returns to the real economy, which is now stuck in a prolonged low-growth phase marred by frequent slippage into recession accentuated by geo-political tensions. Amidst all this, Brexit (Britain’s exit from the EU) is the new uncertainty that would cloud corporate landscape. tocks and bonds investors must brace for lower returns in the coming years, perhaps decades, as the golden era of super returns seems over. The factors and forces that drove exceptional investment returns to investors on the street over the past thirty years (1985-2014) are weakening, and even reversing.
“Past performance does not guarantee future returns,” is greatly truer now and may become even more so in the immediate future than it has ever been in the past. At one fell swoop, another theory of long term investing – time in the market rather than timing the market, is also open to question: How long should the long term really be? Buy-and-hold is dead as timing the market takes precedence over time-in the market.
All investors, individual and professional institutions, especially pension funds, could be severely impacted by these lower rates of return from traded stocks and bonds. As a result, these pension funds could face a funding gap that may be even larger than the one they are currently struggling with. Household savers face the risk of stagnant-to-lower standard of living in the low-returns world.
Given the waves of turbulence that have swept through the financial markets in recent years, it may sound odd to describe the past three decades (1985-2014) as a golden age for investors. Nevertheless, it produced equity and bond returns far above the long term averages for both the US and the Western Europe. This period, besides many other instances, witnessed four major earth-shattering episodes – Black Friday on Wall Street in 1987, Asian Market Contagion of 1997-98, the dot.com bubble of 2000 and sub-prime financial crisis of 2008.
However, despite the international turbulence, India had one advantage – it was the time the Indians had their first crush with equity investing. It happened because the markets became a gateless place after the liberal economic policy initiatives undertaken by the then Prime Minister PV Narasimha Rao. In the process of transforming the country, he implemented his economic goals, and an economic revolution took place which made sure investors flock to the market. With this new found love for equities as well as an increase in size of the economy slowly India registered its name in the elite list of the top five economies in the world. It was again in the same three decades, after almost 15 years of liberalization India recorded its highest GDP growth rate of 9.6 percent and became world’s second fastest growing major economy after China.
But the stock markets are unlikely to replicate the returns of the past 30 years that were lifted by an extraordinarily beneficial confluence of economic and business fundamentals such as inflation, interest rates, pro-globalisation investment-led GDP growth, corporate profitability and re-rating as a result of opening up of the financial sector itself. Even if GDP growth rates were to return to the trend rate of the past 50 years, other factors could dampen annual returns over the coming decades by 150 to 400 basis points compared with the returns earned in the past 30 years. McKinsey Global Institute (May 2016) also indorses this in its report “Diminishing Returns: Why Investors May Need to Lower Their Expectations.”
During the last twenty-one years, the NSE’s Nifty-50, since inception (till June 30, 2016) has delivered CAGR of 10.77 percent, according to National Stock Exchange while the ten year Government of India (GoI) bonds (Gilts) have given annualized return of about 8 percent during the same period.
During 1985-2014, the US traded equities generated annualized total real returns of 7.9 percent and bond investors were handed returns of 5 per cent. The same for Western Europe markets were 7.9 percent and 5.9 percent, respectively. These stock returns are buoyed by the near tripling of the Dow Jones Industrial Average after President Barack Obama’s inauguration in 2009.
Everything in this world is bounded by the limits and hounded by nature. Trees do not grow to the sky. Bull, and for that matter, bear, markets do not last forever. Trends change. They do change when change strikes. Amid this out-of-line challenging environment, investor’s craving for outsized gains are likely to be frustrated.
Many firsts had happened in last 30 years in Indian markets. The BSE touched the four-digit figure for the first time in 1990 and within one and half years in the second week of January 1992, it crossed the 2,000 mark. In the same year after crossing the 4,000 mark it also witnessed unabated selling when the Harshad Mehta scam hit the markets. The markets gyrated in a narrow range till late 1999, and crossed the 5,000 mark, only when the BJP-led government came to power at the Centre. Then came the information technology boom, and after four sleepy years, BSE could cross the 6,000 mark on 2 January 2004. But in a dramatic turn of events it closed above the 10,000 in 2006 – a span of just two years. After that there was no looking back and within a year it doubled when in October 2007 it crossed the 20,000 mark. Thus, BSE Sensex has seen a multi-fold returns over the past 20 years, as the 30-stock index managed to rally from 3,000 level back in 1995 to 28,000 in 2016.
The big decline in interest rates and inflation is reaching its limits with the US and EU having near-zero interest rates and non-existent inflation for a prolonged period. Global GDP growth is estimated lower as populations in the developed world and China age, and the outlook for corporate profits is cloudier. While digitization and disruptive technologies could boost margins for some companies, the big American and Western European firms that took the largest share of the global profit pool in the past 30 years face new competitive pressures from emerging-market companies, technology giants, and digital platform-enabled smaller rivals. These forces may curtail margins going forward.
Plunge At Own Peril
Higher you buy; lower the probability, lesser the amount, of gains and longer the holding period
Don’t jump into the stocks boat that is lifted high on liquidity and has hit the red button on three very popular valuation indicators. In the true spirit of “stocks for long term”, anyone who bought stocks at these ratios at the current levels in the past had to wait for one-to-four years before getting back to even (the par level at which original investment was made). The stock valuations of late have been rising to bull-market ratings, but on muted sales and earnings growth in clear disconnect between the financial markets and the real economy.
Be careful if you are looking to make some quick buck by flipping stocks tomorrow, assuming the talkingheads’ favourite fad to move with the “trend is your friend.” This is not a trend to befriend with that has pushed up the equity benchmark index Nifty 27 per cent in the last four months from 6825 since the budget-day low on February 29.
At current benchmark index prices,
market capitalization to GDP ratio, popularly also known as the “Buffett Indicator” at 80 is at the highest levels seen in the past six years and the long term average of the last ten years. Plunge at own peril as the higher you buy, the lower and lesser the probability to make profits and longer the holding period. The ratio is calculated by dividing the market capitalisation of the stock market by nominal GDP. As of July 29, 2016, BSE’s total market cap was Rs 1.07 trillion and India’s recorded nominal GDP of Rs 1.35 trillion for FY16.
Likewise, the Nifty has hit 24 on the Price Earning (PE) ratio last seen one year ago. Anyone who bought the Nifty when it was trading at 24 PE the last time in July 2015, he had to wait for 12 months to get back the purchase price sacrificing the notional loss on investment for the holding period. Investment decisions motivated more by greed than careful evaluation do turn treacherous quite often. At the current price, 8660 and 23.69 PE, from the same price at same PE last year, indicates that the Nifty has risen only in price without any earnings growth from last year. In other words, the Nifty price has seen re-rating without a commensurate rise in earnings of the constituent companies.
The third popular indicator, Nifty market capitalization to sales, is at 2.33 last seen in 2011 and shows the stocks are pricey based on the amount of sales generated by companies. The stock valuations are rising at a higher rate when the companies’ sales and profits are not growing at the same pace. For the latest quarter 1QFY17 (so far 400 major companies), the aggregate revenue growth is 2.3 percent and adjusted net profit growth at 11.6 percent.
Even in the US, the S&P 500 is trading at a price-to-sales ratio highest in the last 15 years. The higher the price-to-sales ratio rises, the more investors are paying per every dollar of revenue. This may humble investors riding the record breaking S&P 500 rally.
But the same disruptive forces can also create multiple complicated issues in India Inc leading to drop in revenue. However, the bigger challenge comes from the human resources front. As the latest UN report says, with 356 million 10-24 year-olds, India has the world’s largest youth population despite having a smaller population than China. It is easier said than done that with large youth populations India could see the economy soar. Every month, some one million young Indians turn 18. In fact, looking for work, and registering to vote, they are making India home to the largest number of young, working-age people anywhere in the world. This is just part of India’s staggering challenge. Every year, the country must create an estimated 12 million to 17 million jobs to productively use the combustion of this youth power into economic growth. Aspirations, when thwarted, can be a potent, spiteful force. The government can no longer be sure that a large swell of young working-age people will enrich the country, and that’s another problem. This huge labour force is adding to the challenges on the government and the market. They need jobs and without jobs how wealth can be generated?
Anyone who bought the Nifty trading at 24 PE the last time in July 2015, he had to wait for 12 months to get back the purchase price sacrificing the notional loss on investment.
Investment decisions motivated more by greed than careful evaluation do turn treacherous quite often.
Inflation and interest rates declined sharply from peaks in the late 1970s and 1980s. Global economic growth was strong, fueled by positive demographics, productivity gains, and rapid growth in China. And corporate-profit growth was even stronger, reflecting revenue gains in new markets, declining corporate taxes, and advances in automation and global supply chains that helped rein in costs. All the four exceptional factors – inflation, interest rates, real GDP growth and corporate profitability – that underpinned the above-average returns are likely set to change course entailing re-adjustment in our perception about PE and other such valuation ratios.
These lower returns could have a profound effect on all investors—both individual and institutional—and, by extension, on corporations and governments impairing their pension pay-outs. “For example, a two-percentage-point difference in average annual returns over an extended period would mean that a 30-year-old today would have to work seven years longer or almost double his/her savings to live as well in retirement,” the McKinsey Global Institute report says.
Secondly, Indian investors still follow the age old Warren Buffett’s formulae of investment. Those over popularized theories, no longer guarantee returns of the past. Like Buffett’s idea of a wide moat is essentially anything that protects a business from attack by new competitors. Now that firewall is completely broken. And the most important factor, in still a growing economy, is that even over a shorter time frame, sectors can go from boom to bust and business cycles can change.
Therefore, theories and the conclusions based on those must be recalibrated. Money managers whose fees are linked to the returns generated on stocks and bonds, analysts and professional forecasters who had made high-paying career, giving predictions must devise new models and revise the theories to survive on the Greed Street.
“Prediction is very difficult, especially about the future,” Nobel winner physicist Niels Bohr