June Outlook

7 June 2020

The Great Disconnect: Liquidity vs Reality

Markets seem detached from the reality for the moment

1. The Economic Reality

Global lockdowns and the pandemic have fast-forwarded already slowing economies into rapid deterioration.

Economic activities (measured by PMI) across the world have hardly picked up in May and unemployment levels have spiked. Such a dramatic decrease in employment levels, lead to lower consumption in the economy, causing lesser earnings/profits for companies, which further encourages job layoffs. It’s a domino effect.

US GDP contracted by 5% in Q1 2020 and is expected to decline by 40% in Q2, according to Deutsche Bank. The Indian GDP also slowed to 3.1% in Q4 of 2019-20. In the last week of May, the RBI Governor said that India’s GDP will be in negative territory in 2020-21. It is the worst slowdown in India in the past 40 years.

The pandemic, global lockdowns, depression, massive unemployment, demand collapse, bailouts, currency debasement, debt downgrades, social and political unrest - it's crazy but the markets are bullish!

2. Euphoric state of the Stock Markets

In the last 100 days, we have gone from talking about a recession to depression to recovery to euphoria:

The S&P 500 has rallied 42% since its March bottom, while Nifty has risen 33%. These are some of the fastest recoveries seen in the history of stock markets. Note that the US and India made the recent bottom on the same date - March 23, showing there is a correlation between the recent global stock market recoveries.

No doubt absolute stock prices in India are cheaper compared to January. However, if you look at valuations (and almost no earnings in April/May), they are not cheap enough to invest aggressively. The current P/E (market valuation) of the Indian markets is in the top 10% of its history. The Indian economy in contrast is in its worst 10%, perhaps even the worst 1%. This is apparently one of the most impressive mismatches in history.

3. So what’s got the markets skyrocketing?

Answer: The free money from the Fed and central banks all over the world.

The shock of lockdowns to the economies and massive monetary and fiscal stimulation led by the FED in the US put in motion quantitative easing by central banks all across the world.

There is a clear battle between central banks’ liquidity vs the economic reality. The Central Banks’ actions are trying to pull the markets up, while the economic strains try to pull them down. And clearly, liquidity is winning (at least for now), because so much free money just drives up demand for high-risk assets.

Many justify the current rally, by arguing that the stock market is not the economy. Meaning the stock markets stopped being about companies, profitability, GDP growth, earnings, quality management, economic moat, valuations; and are now simply a function of ZIRP and TINA.

ZIRP = Zero interest rate policy

TINA = There is no other alternative

ZIRP is important because as long as Central Banks continue to provide liquidity (simply by printing new notes or keeping interest rates close to zero), it will keep propping up asset prices irrespective of fundamentals. Meaning they will not let the economy fail (which is already happening but since most will incorrectly use stock markets as a gauge of the economy, the FED will do their best to not let the stock markets fail, especially till the US Elections in November).

Since interest rates are negligible, investors globally are forced to invest their money in equities, despite the risk/reward ratio not favoring equity asset allocation. This brings us to the second factor TINA, which is driving up stock prices as more and more investors join the frothy rally, only because they have no other viable alternative, and they fear missing out on possible equity gains if the liquidity continues.

4. If the stocks are up, what's the worry?

A crisis of this magnitude perhaps offers once a decade opportunity to invest for the long term. With someone who has the cash and courage, it would have been great to go all-in had the stock prices been cheap. Cheap valuations would offer a good margin of safety, even if the economy continued to suffer a little bit in the short term. But the valuations aren’t cheap today.

Warren Buffet’s famous valuation gauge, market cap to US GDP is at around 151%, reflecting US markets are in an extremely overvalued zone. There is no history that shows that valuations above 150% are sustainable. It would be unwise to believe that any big correction in the US will not have a ripple effect on Indian markets.

Indian markets were becoming fairly valued at the end of March, but the recent rally has brought them back to expensive levels, especially if we consider rapidly deteriorating earnings. The only constant in investing is that markets tend to revert to their long term average levels, and we are not there yet.

All countries, economies, and investors have accepted that this will not be a V-shaped recovery, but the stock market prices seem to be pricing in perfection or at least that the worst is behind us. Any divergence from this perfect expectation can cause the markets to bleed, maybe slowly but surely.

The world is only temporarily overwhelmed by the Central Banks’ unprecedented stimulus efforts. The current market rally has no fundamental footing. What if the Central Banks were compelled to stop interfering for any reason? What if inflation started creeping in? The problem with investing in a blind liquidity rally is, if there is a slight shock to the liquidity or the central banks give up on pumping money into the economy, the fundamentals will take over and that will not be a very pretty picture.

Covid-19 should have encouraged us to acknowledge the risks in our portfolios, but the actions of the Central Banks have done quite the opposite and made the bubble even frothier than before.

Markets are forward-looking, but perhaps only selectively. Because they seem to be completely ignoring:

• already expensive valuations

• a potential wave of defaults and bankruptcies in the coming months

• a second wave of the pandemic

5. How do you bridge the gap as an Investor?

Stocks are expensive and the economy is terrible.

If you invest today, you run the risk of fundamentals catching up to your investments. If you don’t invest today, you run the risk of losing opportunities if the liquidity continues forever. Both options are okay, as long as you know what risks you run in your portfolio.

While the economic situation looks grim, we remain bullish on Indian equities in the long run, provided they are purchased at the right valuations. For now, our asset allocation is tilted towards defensive assets and we continue to monitor valuations diligently and will take action if the situation allows one.

As a trader, you can profit immensely from these large scale moves in short periods. But as a long term investor, with a focus on capital protection and wealth generation, you need to tread very carefully, or you can get caught in a bull trap.

Sure the rally can continue for a little while longer and there will be green shots in certain sectors like pharma, telecom, FMCG, but you need to be cautious while investing in broader markets. It’s very hard to believe that liquidity can continue to infinity and substitute actual growth in the economy. And if this ends badly, I doubt investors can stomach a second major sell-off in equities in the next couple of quarters.

"Patience while out of the market is more difficult to exercise, than patience while invested in the market."

But practicing patience and prudence seems to be more appropriate today than blind one-sided optimism.