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Warning signs that show equities have reached a bubble stage.
I agree that only God and liars can time the market. But are there ways to protect your portfolios from such excessive falls? I cannot make it clearer but the Feb/Mar 2020 correction was not due to the coronavirus crisis alone, it was mainly due to extremely elevated stock prices, without any support from the real economy. Since February 2018, I have been extremely pessimistic on equities and have given many of my clients a sell call on their large equity positions. Please see my warning from October Outlook 2019.
Me and my clients did not have more than 20% equities in our portfolios during this massive crash. In this post I explain the thought process that allowed me to protect our money, with majority calls in cash/debt.
We must first understand the relationship between the real economy and the stock prices: quick video, click here. It’s simple: A man (the real economy) walks his dog (the stock markets) on a leash (both cannot diverge significantly for too long).
Let’s look at what the real economy was doing since 2018:
The last economic expansion from 2009 till January 2020 was the longest in history. Meaning we were in a late business cycle stage. You have to understand that periods of intense growth are followed by contraction. What goes up, must come down. It is the law of nature (gravity) and the markets. Long term economic growth is never linear or without major drawdowns, hence your market returns cannot be linear. The last crisis was triggered by excessive debt in 2008 and instead of cutting down on debt, companies have only increased it on the back of loose central bank policies. Meaning there is too much free money available without effective utilisation, leading to bubble creations.
Yield curve inversion (where yields on 10 year G-sec dipped below the yield of 3 month papers). Meaning there was a severe shortage of liquidity in the economy. It is considered as one of the most reliable recession indicators. It got triggered in March 2019, for the first time since mid 2007 (last bubble fall).
If you spoke to large business owners in Delhi, Mumbai, Gujarat, etc. in different sectors in 2019 and simply asked them if they had been making money? Most of them said no (barring one or two sectors like chemicals, IT). If all sectors and businesses are not making money, there is something wrong. The truth is the economy never really recovered post demonetisation and GST. Companies were also failing consistently to deliver on earnings and targets. Plants were not running on maximum capacity utilisation, demand was deteriorating, payments were being delayed, defaults were increasing, there were almost no new job creations, or any significant hikes in salaries (all indicating that all companies in the economy were not in the pink of health). Forget companies, the government's current account deficit was getting out of control and the government was not releasing payments for already completed projects. I mean how can you just ignore all this?
Now let’s look at what was gold doing - was it going higher? Yes. It by far had the best year in ages - around 24% gains in 2019 alone. Safe havens like gold start rallying when risk starts building up in other assets and central banks start pumping money into the economy.
Let’s look at what the stock markets were doing since 2018:
The stock prices have been making new highs every now and then since 2018. Ignore the prices, let’s look at valuations (because if you overpay for something right now, you cannot complain if it’s value falls in the future). While I follow multiple valuation metrics, one of the most reliable and easy to understand metrics is the price to earnings ratio. The PE ratio is a band between 12-30 showing how cheap or expensive the overall market is. High PE = Market expensive and Low PE = Market cheap. You want to buy cheap. The best times to buy are when the PE is between 12-19. The PE went as high as 29.9!!! Meaning companies are not earning enough to justify their stock prices. But nobody cared. It was business as usual on Dalal street.
Since central banks all over the world were reading signs about the weakening economy, they started adopting aggressive monetary policies to keep markets afloat and higher by:
Cutting rates excessively again and again, and
Quantitative Easing (pumping liquidity - printing new notes out of thin air)
So what happened when the FED/RBI (and majority of other central banks) kept printing and pumping money in the economy from September 2019? It created liquidity. Liquidity acted like a steroid for the stock markets. Since companies/entrepreneurs were not running on full capacity, they did not want to utilise this money for new projects or businesses. So all this liquidity ultimately found its way to the stock markets, pushing up demand and making the already expensive markets, even more expensive (like this was even possible!!!). Although well intentioned, the excess liquidity only made the problem worse.
A stock market rally based on liquidity alone, without fundamentals is not sustainable. It’s like the central banks tried to get knives to a gunfight. I appreciate the effort though.
So anyway, clearly there was a significant divergence between the man (economy) and his companion dog (stock prices). This divergence will end by either of the two things happening:
Either the real economy bounces back very strongly and stock prices are justified (which could not have been possible since we saw the economy and companies were dealing with too many severe interlinked issues), OR
The stock prices correct significantly and start reflecting the reality of the base economy.
While I had hoped for the economic rebound, I had prepared my portfolios for the latter. The truth is that periods of long economic expansion are followed by significant contraction.
You just cannot have a new wake of economic development without getting rid of the load of the last economic cycle. A correction is healthy in a way, because it gives birth to a new economic cycle.
Personal Notes:
All black swan events are easy to understand in retrospect, just like this note is. But this has not been an easy journey for me and my team. We have been pessimistic against the advice of so many senior people in the industry, at the risk of being proven wrong in the long run. We have lost out on major clients who did not want to hear, “Sir this is not the time for equity, please let us manage your money.” - they didn’t want to hear this because it would make them question all their existing large exposures to equity and who likes to rock the boat, right?
Every time that the market went up, especially the run from September 2019 to January 2020, it made me question my sanity but everything in the real economy and elevated stock prices didn’t seem to add up, and I guess that’s how bubbles are in nature - they don’t make sense.
In this period, I have on many occasions received remarks from my clients like:
“Madam, you are the only one amongst my 5 senior advisors in Mumbai who is giving me an all out sell call. Everyone else is asking me to add more equity to my portfolio.”
“Just a quick feedback, the stock you asked me to sell is now 6% up.”
“Your portfolio in cash is not making any money for me. All my other portfolios are giving me great returns since the last few months of Dec 2019.”
But I have always promised to look after my clients money, just like my own. So if I don’t buy equity for myself, I cannot buy equity for you.
Adding to what Warren Buffet said about investing successfully: be fearful when others are greedy and greedy when others are fearful. I say successful investing is knowing the difference between when to be greedy and when to be fearful.
It’s been an extremely fearful time for us here at Emerald from 2018 - till date. Our time to get greedy has come. We will deploy in parts. Not too optimistic, not too pessimistic. Just trying to do our best as we walk a tightrope.
I will not get 100% things right for you, but as long as I don’t get them 80% wrong for you, you and I will always make money together in the long run.
Please note multiple people had sounded the alarm bells about the stock markets even before the Corona virus scare:
Key Takeaways:
Mean reversion happens. Broad market valuations reverted to the average of 19 PE after this crash. Most justified the expensive markets saying, “it’s different this time because…(of whatever reason they make up).”
Have a 360 degree view of the economy, past historic cycles, understand ability and limitations of the stock markets, recognise exhaustion in an economy, track equity valuations. If you cannot keep up with these things, find a money manager who can.
Money also follows the Pareto principle. What stock or mutual fund or PMS you buy will make 20% of the difference to your overall returns. What value you buy them at will make 80% of the difference.
While most portfolio managers are managing you, my focus is on managing your money. Always check whether your money manager has the intention and ability to look after your money? (Disclaimer: portfolio managers earn more money if they buy equity for you - cause who will pay 1.5% management fee to keep your money in public sector bonds?).
In the long term markets are impacted by: macro economic factors, equity valuations, some technical factors. In the short term markets are impacted by: liquidity, sentiments, specific events. But macro economic factors and equity fundamentals are the only things that work and are most reliable.
Fun Fact: Warren Buffet was sitting on a pile of $128 billion dollars in cash before this massive crash :)