With much of future gains frontloaded, returns to moderate from hereon even if markets remain elevated.
Risk is a dirty word now. As the Economist’s recent lead story quipped, there is bull market in everything. The only asset class that has crashed recently is “volatility”. By implication, it means that risk has crashed to new low if one takes volatility as a measure of risk. In other words, high returns that markets are delivering are coming amid vanishing risk. It is tantamount to saying markets are rewarding double digit “risk free” returns. That should challenge even the novice proponent of basic financial model, leave alone the masters of finance. Such aberrations are possible for a brief period on temporary disruptions like liquidity spike etc, but projecting that into sustainable future returns would be suicidal. In such a situation, one of them has to give in. Either the risk (volatility) has to come back into play or returns have to regress meaningfully.
Lot is priced-in!
Indian markets have priced in all possible positives, leaving nothing to chance. Be it stable political formation far in 2019 or quick recovery in investment cycle and thereof in earnings in FY20 or projecting macro sweet spot of moderating inflation amid low interest rates far into future etc, markets are in no mood to see any slip-ups on any of these. Look at all the exits (promoters and VCs) around in IPOs, QIPs etc, it is not difficult to infer that the markets are priced to perfection. As per one of the statistics, almost 80% of the money raised in the primary markets has gone, not into new capital raising, but for the exits of the VCs and promoters. It is more of a primary trade than the real fund raising. It points to India Inc’s low level of confidence to invest ahead for the recovery.
The other place to look for cues on how frothy the market has become, is to study closely how goal posts start shifting in valuation metrics. Take the case of cyclicals where the shift has been surreal. From valuing cyclicals on normalized earnings, market has moved myopic to value them at high-teen multiple on the peak cycle earnings. The case in point is the valuation in cyclical stocks like HEG and Graphite. Across the spectrum, valuation metrics are shifting to manic levels. History tells us what happened to such salubrious stock prices when sanity returned later.
Madness doesn’t stop there. Look at how collection (portfolio) of otherwise freely traded stocks gets seductive oversubscription just because they are elegantly packaged as ETF. If that is not crazy enough, a leading wealth management companies got away with raising tens of thousand crores under its Alternate Investment Fund to tap into the much fancied pre-IPO space, just when the Big Bull of Indian market fears bubble in the IPO segment. Flows into such fancied structures have become frothy so as to distort valuations to dangerous levels across spectrum.
When stocks are priced to perfection, what next?
If anything the above prognosis points to, it is the manic mis-pricing on the upside for much of stocks. When markets are priced to such (im)perfection, two things can happen. One, if some of those sanguine macro assumptions (listed above) slip, volatility could come back with vigor to haunt the hallucinated markets. Second, even if the slip-ups don’t surface, future returns would be fragile as lot of it is already front-loaded in the current price. If so, sitting on the sidelines is a safe and smarter option for the sane investor (if you are not already invested) as it gives at least 50% chance for an entry opportunity if the markets slip, or in the worst case, no great loss of returns given the limited upside from here on in the medium term. If one is fully invested, selective and phased pruning to build cash levels is a prudent option.
Where do you hide?
Is there a way to ride this reckless phase without taking too much market risks? How do you get the money to work in such a sticky situation? This is where Warren Buffett’s “Workout” wonder comes into play. It is Advantage Arbitrage. The trick is to tout for tactical short-term opportunities, but without taking the market risks. Event based arbitrage is one such tactical model that can help to add glitter to the portfolio without carrying the MTM (mark-to-market) risks. They are primarily short-to-medium term opportunities driven by event based corporate actions like buyback, open-offer and other special situations including mergers, demergers and delisting. The most interesting aspect of this tactical allocation model based on arbitrage is that, while it enhances the portfolio returns in the short-term by serving as a superior substitute for cash parking, it releases the cash at the most opportune time (during corrections) for enabling long-term portfolio building.
Economy to look up, markets to meander?
There is a growing view that the economy is on the mend. It is well debated and settled that the worst is behind for the economy. It can only look up from here on, though the pace of acceleration can still be debated. More so, if one goes by the endorsement the Govt.’s policies have received from the global credit rating agencies including Standard & poor. It is more or less clear that the short-term impacts of both GST and DeMo will fade away and growth will return quickly, though breakout from 7%+ range will take a while. What is not settled and still being debated is what markets would do. Fund managers across the spectrum admit in private, that markets have run far ahead of fundamentals discounting everything but the kitchen sink. Markets and economy has been out of sync for long. So far, it has been the case of languishing economy and mesmerizing markets. Going ahead, roles may get reversed with meandering markets on one side and energized economy on the other side. As has been argued in the cover story of this column, future returns are expected to regress in the medium term even as the economy starts progressing, though in the longer run they will synchronize again.
Fund managers of mutual funds worry in closed rooms that the continued deployment in this elevated markets is sure to attract law of diminishing returns for the investors in future. But they continue to play to the tune given the risk of otherwise under-performance in the short-term if they don’t dance to the music. Surging domestic liquidity has led to complete vanishing of volatility this year as reflected by one-way run in the benchmarks. This is the first time in many years the markets have returned positive returns month-on-month for a row barring few months in this calendar year. While some of the pundits have rushed in to claim this as new normal, other seasoned ones are more cautious claiming this as an aberration which will get normalized by either price action or by time correction. Increasing supply of papers from IPOs/QIPs or from govt.’s divestment could trigger such an adjustment though markets have so far evaded such a spillover effect in spite of surge in supplies.
This does not mean that the meandering markets will not give meaningful stock-specific opportunities, though they will be far and few as the party gets more pompous. Needless to say, this is time for caution and prudence, as has been emphasized many times in this column. Pruning frothy positions to raise cash levels is one of the ways one can exercise such prudence in this ebullient market.
Happy Value Investing!!