Vijay Kumar Gaba

“Courage is the strength in the face of danger, pain or grief, while stupidity refers to behavior that shows lack of good sense or judgement.”

From recent interactions with the market participants, I conclude that the recent ~8% rally in the benchmark Nifty50 has materially obliterated the fear of major correction in stock prices from their minds. Of course, most of them are conscious of the factors like financial sector crisis in the developed markets, especially the US; recession like conditions in some of the major global economies; and high real rates impeding the global growth that may have serious repercussions for the Indian economy and businesses. They also seem to be mostly ignoring the unusual weather conditions and possibility of a serious slowdown in exports, and acceleration in FPI outflows if the credit conditions continue to tighten further in the developed economies.

It may be pertinent to note that banks in the US are tightening credit in response to fed rate hikes, economic uncertainty, and money supply contraction. Historically this has led to a marked slowdown in growth, deflation, rise in employment; large number of bankruptcies and significant sell off in global risk assets.

Average 30yr fixed rate mortgage in the US is at ~6.5% and 5yr auto loans rates at ~7.5% are close to the highest in two decades. Might be this time it is different, but it would be imprudent to completely ignore the risk.

If you can look into the seeds of time, And say which grain will grow, and which will not, Speak. (Shakespeare, Banquo -Scene III, Act I, Macbeth)

The past three years have seen an intense war between the forces of “Greed” and “Fear” in the financial markets. Both the forces have won some battles and lost some. Though the benchmark indices close to their all-time high levels might give an illusion of decisive victory of for the forces of “Greed”; but the negative market breadth, poor volumes, declining participation of the domestic institutions, net selling by the foreign institutions and underperformance of the broader markets in the past one year indicate that the forces of “Fear” have not yielded much ground.

The period 2020-2023 has seen some localized bubbles in the markets, e.g., new age businesses (ecommerce, digital payments, gaming etc.), healthcare (Covid spending) and metals (supply shortages); which have been duly normalized without much damage to the overall market structure. For the 3yr period, the NIFTY IT is still yielding an absolute return of 93%; Nifty Metal is up 166% and Nifty Pharma is up 60%.

There have been two major drawdowns in the benchmark Nifty. The first one was the panic fall due to the outbreak of Pandemic (33% fall during February 2020 to March 2020), which was fully recovered in the next 8 months by November 2020. The second drawdown was due to the geopolitical tensions in Europe (16% fall during January 2022 to June 2022), which was fully recovered quickly in the next five months by November 2022.

For the period of three years, the broader markets are still sharply outperforming the benchmark Nifty. The Nifty Midacp100 is higher by 95% and Nifty Smallcap 100 is higher by 79% as compared to the Nifty50 which has gained 55% in the past 3 years. However this ought not be construed as a decisive victory of the forces of Greed. The anecdotal evidence suggests that numerous new investors who entered the market (or increased their participation materially) in late 2020, may have materially underperformed the benchmark indices; even losing their capital in many cases. Unmindful leverage, excessive trading, ill-advised exposure to poor quality businesses and/or new age businesses at unsustainable price levels may have caused them to underperform or lose capital.

Sharp decline in the value of cryptocurrencies in the past couple of years, almost no return in gold and very poor return in the debt has also impacted the investors’ sentiments in the past one year particularly.

Standing at the threshold of the New Year 2023, both the forces appear tired and looking for fresh supplies. The forces of fear are anticipating a full blown global recession and sharp decline in the global risk appetite; whereas the forces of Greed are looking for a managed slow down followed by a full recovery.

In the context of India, the forces of fear are expecting a full blown balance of payment crisis, higher fiscal deficit, de rating of PE multiples due to failed earnings recovery, and abortion of nascent capex cycle. On the other hand, the forces of Greed are relying on continued government support to capex, strong flows on economic outperformance and stable financial system, peaking of inflation and rate cycle, lower energy prices, fair valuations, and earnings surprises to support their cause. It will be interesting to see how the battle evolves. 

 In the past one week, I discussed the current situation in the Indian financial markets with some seasoned investors and experienced market participants. It was after almost three months that I got an opportunity to discuss the markets with such an enlightened group of people. Mood of markets definitely appears to have changed remarkably since June 2022.

After my interaction with some senior market participants (bankers and investors) I had noted that the mood was rather despondent. The consensus in June appeared strongly in favor of a slow grind over the next 6-9months. The reference point of discussion was mostly the 2008 market crash. The market participants sounded cautious about rising cost of funds and drying liquidity; and feared major defaults that could trigger a global contagion. (see here).

Reactions of the market participants this time were diametrically opposite. Most of them were in fact trying more to convince themselves about “all is well” rather than discussing the market conditions objectively. They refused to acknowledge that the global macro conditions have deteriorated materially in the past three months, led primarily by Europe and China. They argued forcefully in favor of a “decoupled India” and “TINA”. Despite no visible improvement in Indian macro conditions; below par corporate performance in 1QFY23 and dark clouds over export growth that have sustained the 1.4% CAGR for India’s GDP in the past three years.

The platitudes like “Decade and century of India”; 5^th largest economy ahead of the UK” were advanced with impunity; as if they are trying to justify change in their stance from “extreme bearishness” to “cautious optimism” and “uber-bullishness”. Some of them even claimed that they did never advise underweight on Indian equities.

The prices of publicly traded financial assets like equity shares and bonds etc., is materially influenced by the sentiments of fear and greed amongst the market participants, at least in the near term. The sentiment of greed drives the participants to bid higher prices for a security, even though the economic fundamentals underlying that security may not fully justify such price. Similarly, the sentiment of fear prompts the market participants to offer the securities held by them at relatively cheaper rates. The equilibrium of sentiments of greed and fear keeps the markets stable & healthy; whereas dominance of either sentiment induces excessive volatility and irrational pricing in the markets. Extreme dominance of either sentiment usually marks the peak or bottom (as the case may be) of a market cycle.

If we examine the current equity market behaviour, it appears that the sentiment of fear is gradually becoming dominant amongst the market participants. The following five signs, for example, indicate that relatively weaker participants might be moving to sidelines or even withdrawing from the markets. This is usually indicative of the beginning of the process of a market cycle completing its downward journey. The actual bottoming though may take some time and further downward move.

Market activity shrinking

In the past six months, the market activity has cooled down conspicuously. The volumes in INR terms as well as in terms of shares traded and number of trades executed have remained on the lower side, indicating shrinking participation in the market.

At peak of the market in October 2021, the average traded volume in Oct’21 was over INR4000bn; however in May’22 it contracted to was below INR2800bn. Similarly, the number of trades in Oct’21 was over 130bn; whereas in May’22 only 108bn trades were executed on NSE. In terms of number of shares traded – in Oct '21 83.58bn shares were traded on NSE. In May’21 the number had contracted to 43.91bn, almost half of Oct’21.

 

Volatility persisting at higher levels

Since the benchmark Nifty recorded its all-time high level in October 2021, the implied volatility (popularly called the fear index) has persisted at higher levels; even though it has eased in the past 10 days.

Broader markets underperforming

The market breadth has remained negative in eight out of the past twelve months. The market breadth on NSE was worst in at least the past twelve months. In fact the market highs in October 2021 were recorded with a negative market breadth and high volumes; indicating a distribution pattern in the technical analysis parlance. Nifty50 has corrected ~10% from its latest closing highs; whereas Nifty Smallcap 100 index is down ~23% from its latest high levels; even though the smallcap high (January 2022) was recorded 3months later than Nifty (October 2021).

Sector wise also YTD 2022 only Financials (1%), FMCG (1.5%), Auto (5%) and Energy (14%) sectors have yielded positive returns. IT Services (-22%), Realty (-15%), and Pharma (-12%) have been the worst performing sectors.

 

Valuations are now more reasonable

As the sentiment of fear has started to dominate the markets, the valuation excesses are now correcting. The 12month forward PE Ratio of the benchmark Nifty Index is now closer to 5yr average level. The price to book (P/B) ratio for Nifty has also corrected sharply from the higher levels seen in October 2021.

The valuations are now closer to “fair value” zone, a pre-condition for completion of the down leg of a market cycle (bottoming). It is however important to note that in many cases it has been seen that the earnings estimates are materially revised lower. In that case the “fair value” curve may shift sharply downward. 

Global markets – sentiments most bearish since March 2020

As per the Bank of America’s (BofA) proprietary Bulls and Bears Indicator, the global fund managers were most bearish in May 2022, since the Pandemic outbreak (March 2021).