Aarati Krishnan

Why the correction must run its course

Aarati Krishnan | Updated on March 20, 2020 Published on March 19, 2020

The recent bear phase, far from being irrational, was badly needed to align frothy valuations of Indian stocks with their fundamentals

As the US stock market lurches from circuit to circuit and Indian markets go into full panic mode after shedding 30 per cent, there’s growing clamour for the market regulator to ‘do something’ to the stop the declines.

Given that this bear phase is not caused by economic events but by a renegade virus, why not shut down all trades until better clarity emerges, argues one camp spearheaded by the Venture Capital community. Another camp points to the short-selling bans imposed by global regulators and asks why India can’t follow suit.

While these appeals are made in the interest of long-term investors, in the current context, shutting down markets or banning certain kinds of trades can hurt the interests of such investors, rather than help them.

In the interests of investors who have put faith in Indian stocks for a good long-term return, stock prices sorely needed to correct from their super-charged levels. Yes, one wishes that the trigger for it did not have to come from a pandemic with such devastating human costs. But the correction itself was inevitable, given unsustainable valuations.

Hope rally

If the market fall triggered by a global pandemic is unprecedented, the bull market that preceded this decline was quite unique too. It stood out for being the longest hope rally in recent memory, when stock prices soared with very little support from earnings.

Sustained bull markets in India over the last three decades have always been supported by a sharp earnings pick-up. In the bull market that lasted from April 1993 to February 2000, the BSE Sensex more than doubled, powered by high earnings in sectors such as pharma, FMCG and the IT-media-telecom triad.

While the Sensex rose at a 15 per cent CAGR (compounded annual growth rate) in this seven-year period, earnings of Sensex companies grew at 16.7 per cent CAGR. It was only when tech company earnings began to sharply decelerate post Y2K, that the Sensex PE of 24 began to look expensive and the rally abruptly ended.

The bull market that lasted from December 2001 to January 2008 was similar. While the Sensex registered a 27 per cent CAGR, the profits of its constituent companies, powered by capital goods, infrastructure and real estate players this time, increased at 19 per cent a year. It was when corporate profits hit a speed-breaker in the form of the global financial crisis in FY08, that Sensex valuations of 26 began to look expensive and had to de-rate.

But the recent bull market that ran on from December 2011 to December 2019 was very different, as the breathless run in the indices was unaccompanied by any earnings pick-up. It has run on thanks mainly to the flood of global liquidity let loose by the easy money policies of central banks.

While the Sensex registered a 13 per cent CAGR between December 2011 and December 2019, earnings of Sensex companies grew at barely 6 per cent a year. This led to the Sensex PE expanding from about 16 in end-2011 to 28 by end-2019.

In effect, market valuations have shot past previous bull market peaks and stayed there for the last four years (the Sensex PE has hovered above 20 times since 2016), without much fundamental basis. While analysts have been repeatedly hoping that this mismatch will be corrected through a 20-25 per cent earnings jump in the last four years, these hopes have been foiled time and again.

With the virus outbreak now signalling an indefinite pause in economic activity and a possible decline in earnings, the Sensex PE of 28 turned positively frothy and eminently deserves to correct. The recent decline has levelled the PE to 17 — in line with long-term averages, but not dirt-cheap.

Effectively, the correction, far from being irrational, was badly needed to re-align Indian stock valuations with fundamentals. Shutting down markets for any length of time is therefore unlikely to prevent it from running its course.

Entry valuations matter

What of the domestic retail investors who have poured money into equities in the last five years? Won’t they be hurt by the fall? Yes, in the short run, they will. But in the long run, a bear market gives them a better shot at healthy returns by averaging their high purchase costs.

It is worth noting that nearly 60 per cent of the equity assets managed by mutual funds today (₹6.5 lakh crore of the ₹11 lakh crore) have been added post-2015, at pricey Sensex valuations of 22-plus. This is worrisome for the long-term return experience of investors.

Contrary to perception, making double-digit returns from equities isn’t simply a matter of buying and holding stocks for 10 years. The valuation at which you invest is a big decider of returns. A monthly rolling-return analysis of the BSE Sensex over two decades shows that the Indian markets delivered a single-digit return for 10-year investors a good 46 per cent of the time. If the Sensex starting valuation was at 22 or above (1994-2004, 2007-2017, 2010-2020), investors often made sub-5 per cent returns over the next 10 years.

But when starting valuations were at 15-18 (2001-2011, 2009-2019), it was much easier to get to 15-20 per cent returns. The best 10-year returns, in fact, were made by investors who were intrepid enough to buy equities during the panic unleashed by the 9/11 attacks and the global financial crisis.

For long-term investors looking for attractive entry points into equities, taking on near-term uncertainty on the economic outlook or earnings is inevitable. Therefore, far from being protected from equities at times like this, Indian investors need to be encouraged to look beyond such volatility to take a long-term view.

SIPs are bear-friendly

Those worried about retail investors getting permanently scarred by this fall can also take heart from another distinctive feature of the recent bull market as against previous ones. Compared to previous bull markets. when Indian retail investors took direct punts on stocks, most first-time investors now take the mutual fund Systematic Investment Plan (SIP) route.

AMFI data tells us that the SIP books of mutual funds have more than doubled from ₹43,921 crore in FY17 to nearly ₹1 lakh crore in FY20, with about a third of the annual equity flows now coming in through this route.

SIPs as investment vehicles are specifically designed to help investors take advantage of falling markets by averaging their costs; they are quite useless in steadily rising markets. Therefore, the current bear market, far from being hostile to retail investors, is just what the doctor ordered for the three crore SIP investors in mutual funds.

Overall, SEBI is doing quite the sensible thing by not heeding calls for curbs on short-selling or market shutdowns. All it needs to do is ensure orderly functioning of markets and payment systems, so that retail or institutional investors trying to look beyond this mayhem are not denied opportunities to participate.

Short-term investors, in any case, thrive on volatility and are agnostic to whether they bet on long or short trades. Those who have no stomach for the roller-coaster are free to quarantine their trading terminals until the virus abates.

If the mutual fund fraternity is worried about retail investors making the wrong moves in the grip of panic, this is better addressed through awareness campaigns that highlight the right course of action at times like this (stick to your asset allocation, don’t invest less than five-year money in equities, and so on). A bear market is a more opportune time to run a “MF Sahi Hai” campaign than a frothy one.

Published on March 19, 2020
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