Is The Cart Pulling The Horse?
The stock market is the barometer of the economy." This was a statement that examinees had to defend or challenge in an examination during my graduation in Business Economics in 1992. I defended the statement, at a cost. My generation was right in the middle of the biggest ever market mania in India. Robert Shiller recorded it as the eleventh largest 'Irrational Exuberance' of any financial mania in human history. Yet, my choice to defend the role of markets as a barometer of the economy arose from a strong belief that markets incentivise those who anticipate better. My professor, a well known and accomplished economist in those days, snarled that John Maynard Keynes had asserted that the "stock market can remain irrational for longer than one can remain liquid". He further fumed that even investment guru Benjamin Graham had asserted the involvement of sentiments in security prices. Today, a somewhat similar situation has arisen. There is frenzied super-valuation in high quality stocks with high earnings visibility, but economic numbers trend lower. Evidence suggests a flight to safety. Since the euphoric first high in this current zone of Sensex and Nifty (January 2018), the key indices have fluctuated about 10 per cent. Several new highs have come and still Nifty relapsed to near 10,000 every time. What it took me many years to figure out is that irrespective of the methodology deployed to construct stock indices, there are many layers to the stock market. For instance, the Nifty Midcap Index is 23 per cent lower and the Nifty Smallcap Index is 40 per cent lower from the January 2018 peaks. Yet all attention is on Nifty 50. The flight to safety indicator plots the ratio of prices in Nifty 50 versus the summed prices of the Nifty Midcap and the Nifty Smallcap indices. This ratio reflects the unwillingness of capital to percolate into less liquid, less stable and yet much higher returns stocks. With Nifty on a high again, the flight to safety indicator is at its peak. So, the mood of the markets is in line with economic performance. A trend analysis of the smaller-cap indices is not reflecting bottom formation yet. A further 30 per cent cut seems feasible. Nifty, however, is expected to mimic the new highs that Sensex is likely to reach in the weeks ahead, a 12,250 level at the most. Thereafter, a slide back to the 10,000 area would complete an almost two-year-long sideways correction. Among small- and mid-cap companies, erosion in earnings and valuation has driven them lower. In the large-cap space, there is a fear of being left out of the India growth story, especially vis-a-vis the tepid global growth outlook. The fear of being left out has been exacerbated by the high-octane and high-determination structural reforms and shifts of Modi 2.0. In my trials in the markets through three decades, whenever I leaned on fundamental analysis, I only got part of an answer. Each individual can have their favourite perspective on the possible factors. But the vector sum of all hypotheses, conjectures and insights is market price. Only when a market move has occurred does everyone agree to its best explanation. And since uncertainty is the origin of returns, market-men agree upon the fitting answer after the moves have occurred. The finale to the current sideways correction in Nifty and Sensex could culminate in the early part of 2020, whereon true animal spirits will revive, first in the markets and a few quarters later, in the economy. Common sense dictates this deep catharsis to take place in mid and small caps, which will produce extra-ordinary returns for several years. This will happen since large-caps' valuations are saturated. Big turns in the economy are accompanied by confusion and anxiety. So, investors should undertake a deep study of the businesses and companies they would like to own for years to come, and conserve capital by trading lesser in markets at this point. The writer is founder, Kedianomics, a market research firm.