Do it yourself: stock market bubble

Wednesday, June 19, 2024

Elementary economics – Chapter 1

One of the basic principles of economics is that no one makes abnormal gains (or loss) from an economic activity over a longer period. The forces of demand and supply tend to attain a state of equilibrium as higher margins attract more supplies and lower margins push the marginal suppliers out of the market. In the short term, however, suppliers can make super profits taking advantage of the demand-supply inequilibrium. Most economic activities thus follow a cyclical path rather than a linear path.

This principle does not apply to the states where markets are not free and monopolies with state protection and patronage are allowed to thrive at the expense of consumers.

We have also witnessed that businesses that own niche intellectual property rights (IPRs) or ownership of scarce natural resources have defied this principle for a much longer period of time, as compared to the usual businesses.

Applying this principle to the current market scenario, I find that the investors may be ignoring this elementary principle in their growth and profitability assumptions for the basic engineering businesses like Solar & Wind equipment & EPC, Railway equipment & EPC, Defense electronic & war equipment, and low margin electronic manufacturing, etc. Most global solar panel manufacturers are already struggling with oversupply issues.

Most analysts are projecting a linear growth for these businesses over the next several years. They are valuing these businesses on the basis of multiples of order book and sales.

I have not read any research report that says, “the fabled electronic manufacturing services (EMS) business is akin to garment export business. Its low margin assembly business which would require consistent capex and government support. These businesses will face stress every 3 to 5 years when their contracts come up for renewal. All of them carry the risk of the OEM going out of business which might take them along into a deep pit.”

Recently, ISRO chairman S Somanath “highlighted the challenges faced by the satellite launch market, stating that rockets are available but there is a lack of demand. The market is depressed, and even companies like Arianespace struggle with profitability without government subsidies. The main issue is that there are a limited number of players in the satellite market, leading to fierce competition. To address this, there is a need to create internal demand and a robust ecosystem, as waiting for foreign satellites is not a sustainable approach”. (Economic Times, 17 June 2024)

There is a rush to buy the defense tech indigenization and export theme. Demand for the stocks of potential drone manufacturers far exceeds the supply, resulting in an exponential rise in stock prices. Investors are not recognizing that in countries like the US and China, high school students are learning how to design and manufacture drones. Artificial intelligence (AI) may make conventional weapons redundant in no time. The future wars may be fought in cyber space rather than the battlefields with guns and missiles. The ongoing Russia-Ukraine war is a classic example of the complete failure of conventional weapons and war strategies.

The following meme regarding popularity of Electric Vehicles most aptly sums up the fallacy of these popular investment themes. (Sourced from social media, copyrights fully acknowledged)

Investors accepting the promise of 100% EV vehicles in two decades must assess the scenario where the copper price exceeds the gold price!!!

Thursday, July 23, 2020

Su karwa nu?

The decoupling of real economy and financial markets in past few months has certainly caught many market participants by surprise. There is no dearth of experts and masters of market who are claiming to have caught the March bottom and minted money. I have no doubts that they might have actually achieved what they claim. However, the publically available evidence suggests that most mutual funds have yielded negative return in YTD2021 and in past one year. The 5year return is worse than the average fixed deposit interest in this period.

The investors are thus caught in a quandary - whether they should use this bounce in the stock prices to redeem their investments or invest more money.

The problem in fact seems more acute with the investors who decided to play "safe than sorry" and redeemed their investments during March-April and are sitting on the fringes. Many of them are wondering whether it is a good time to invest back in equities; especially when the debt and money market returns have plunged sharply.

The questions I get these days vary - "su karwa nu?" (what to do?), "Kya lagta hai?" (how does it look?) "kuch karna hai kya?" (is there any investment/trading opportunity?), being the most common ones.

I do not believe in this entire FOMO (fear of missing out) theory of investment behavior. I believe that this is just a deceptive jargon to describe the unexplained part of the investor behavior.

In my view, it is perfectly normal and acceptable behavior for investors and traders if they do not find it desirable to venture into rough seas and prefer to wait in their cabin for the weather to clear out. It they are looking for assurance that the storm has passed and it's safe to sail now, this is a prudent behavior not fearsome.

My answer to the inquisitions of investors/traders who chose to retire to the safer confines of their respective cabins is as follows:

(a) The economic storm triggered by outbreak of COVID-19 virus is far from over. The economic consequences of the disruptions caused by global lockdown will continue to unfold over many years to come. I do not expect Indian economy to regain sustainable 6%+ growth trajectory (normalized for FY21 extraordinary fall) in next 3years.

(b) The asset prices, especially equities and precious metals, may continue to rise in short term, due to abundant liquidity; lower cost of funds & poor debt returns; lower capital requirements in routine businesses;

(c) There is no sign of bubble as yet in the market, as even the 3-5yrs returns are abysmal. The valuations appear stretched due to extraordinary fall in earnings. The negative real interest rates may afford higher valuations to sustain in the short term (12-15months).

(d) The market breadth has started to narrow again. In my view, this trend may accelerate in 2HFY21. I will not be surprised at all to see the benchmark indices scaling new highs in next 9-12 months, while the broader markets languish or correct materially from the current level. Too much diversified portfolios therefore may continue to underperform the benchmark indices.

My suggestion to the readers, who have asked these questions, is as follows:

Follow a rather simple investment style to achieve your investment goals. It is highly likely that most may find this path boringly long and apparently less rewarding, but in my view this is the only way sustainable returns could be obtained over a longer period of time.

I believe, taking contrarian views, anticipating short term performance (e.g., monthly sales, quarterly profits etc.) and reacting to that, or arbitrage on information/rumor of a corporate action are examples of circuitous roads or short cuts that usually lead us nowhere.

Taking straight road means investing in businesses that are likely to do well (sustainable revenue growth and profitability), generating strong cash flows; have sustainable gearing; timely adapt to the emerging technology and market trends, and most important have consistently enhanced shareholder value.

These businesses need necessarily not be in the “hot sectors” like commodities in early 1990’s, ITeS in late 1999s, or infrastructure and financials in 2004-07. These businesses may necessarily not be large enough to find place in benchmark indices.

I have discussed it many times in past. However, given that the market is in a prolonged period of high volatility and low returns, making investors jittery and indecisive, I deem it fit to reiterate. Of course there is nothing proprietary about these thoughts. Many people have often repeated it. Nonetheless, I feel, like religious rituals and chants, these also need to be practiced and chanted regularly.