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Markets On The Boil? Ask Buffett

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Markets On The Boil? Ask Buffett
Markets On The Boil? Ask Buffett
Vishav - 29 August 2021

Before the Covid-19 pandemic struck India, and took it by a storm, the domestic equity markets were doing quite well, even though there were some concerns surrounding an economic slowdown

The Nifty traded in the range of 12,000s and market experts forecast it to hit 14,400 by the year-end. In fact, that was among the most aggressive forecasts. And when the pandemic hit, the NSE benchmark crashed to around 8,000 points in a matter of weeks. It was natural, given that the next few months saw India’s quarterly GDP crash from around Rs 38.3 lakh crore in the fourth quarter of 2020-21 to around Rs 27 lakh crore in the first quarter of 2021-22.

So, a knee-jerk reaction from investors did not seem too irrational. However, since then, the equity markets made a remarkable recovery not only reaching their pre-Covid highs, but also surpassing them significantly. The Nifty traded near 17,000 points in late August. This was not only twice its value from the lockdown lows, but also a good 33 per cent higher than its pre-Covid highs.

The shocking fact is that during this time, when equity markets went over and beyond their previous highs, the GDP was only catching up. While the Nifty had gone past the 15,000-mark by March, India’s GDP in the January-March quarter was Rs 38.9 lakh crore, barely crossing the FY21 fourth quarter levels of Rs 38.3 lakh crore. This dichotomy has led many experts to believe that the Indian markets are in an overheated zone. One may wonder why GDP should be given so much importance while estimating equity market levels.

But it is so, says investment giant Warren Buffett. The Berkshire Hathaway chief judges a stock using the ratio of market capitalisation and GDP. Buffett Indicator, as the ratio is called, is one of the most potent ways to analyse stocks.

Indian Markets Overheated?

Despite the clear dichotomy between the performance of the country’s economy and the stock markets, there is no consensus on this. On one hand, many believe that the Indian markets are overheated, others feel the economic factors are conducive to sustain much higher levels.

According to Dr Suresh Srinivasan, Professor of Strategy and Program Director, Great Lakes Institute of Management, Chennai, asset bubbles across all classes of assets have been created through the positive sentiments emerging from the availability and access for vaccines, clubbed with the low interest rate regime and liquidity, huge fund flows from foreign portfolio investors and speculators. He says the stock market is, by no means, an exception.

“The global and national economies have taken a solid blow due to the pandemic, frequently compared with the recession of 2008 or the World War II recession. Corporate results in terms of topline and bottomline have steeply dipped. Ironically, the stock markets are touching unprecedented highs, resulting in a huge disconnect.” says Srinivasan.

Deepak Mullick, author of SimplyMutual – The 1% Formula to Gain Your Financial Freedom, says the “markets seem to be reasonably valued” given the combination of factors of low interest rates, high global liquidity, and the fast pace of economic recovery with most businesses settling into the new-normal way of doing business.

The Indian economy is still slated to be the fastest growing large GDP that changes the perception of an overheated phase to reasonable or even cheap in a matter of a couple of quarters. With the Indian market capitalisation and GDP, both around $3 trillion, the Buffett Indicator is hovering at 100 per cent, a little over the long-term average, but with good projected earnings growth for current fiscal year and the next. With this indicator also, we seem to be reasonably valued,” he says.

Buffett Indicator: Relevance to Indian markets

Srinivasan shares that the indicator is frequently modified to use Gross National Product instead of the Gross Domestic Product. Modified Buffett indicator also adds the assets held by the central bank to the GDP in the denominator. In essence, the metric indicates how expensive the stock markets are at any given point in time and is widely used by investors around the world, especially comparing it with historical values.

“In spite of its many limitations, Warren Buffett believes that this is the single best, and a simple metric, to assess the level of overheating of the country’s stock markets,” explains Srinivasan.

According to Nikhil Kamath, Co-founder, True Beacon, the Buffett Indicator allows investors to gauge the situation and participate in markets carefully. “The present value of above 100 is lower than the historical maximum of 156.25 per cent which was seen in the peak of 2007 markets. It is on the expensive side when compared to emerging markets and China, but undervalued when compared to the US and Japan which stand at 208.5 and 148.98. If we just use the Buffett Indicator, the expected stock market return is 3 per cent a year for the coming few years but we can’t use just one valuation metric for prediction or comparability,” he says.

There will be a bull market for select sectors like IT, consumer foods and pharmaceutical as the earnings were resilient even during the previous two Covid lockdowns, and select undervalued opportunities in these sectors should do well, according to Kamath.

Also, one should be careful with sectors like auto and refineries as their earnings may be impacted if lockdowns are imposed in future, if any third Covid wave and related disruptions are realised.

Applying Buffett Indicator

According to Deepak Singh, Chief Business Officer at Reliance Securities, market cap to GDP metric should be applied when there is no aberration about GDP growth like we saw last fiscal due to pandemic.

“Based on the current market cap of Indian equities, India’s market-cap-to-GDP-ratio certainly looks higher compared to other emerging markets and its own historical average. However, this valuation looks optically higher due to sharp contraction in GDP last fiscal. Hence, this indicator may mislead in the current scenario to take a judicious call about domestic equity. While Buffett Indicator is a right approach to gauge the status of equity market in any country, it should be considered in the context to normalised economic scenario,” Singh says.

Deepak Mullick believes Buffett Indicator cannot be taken in isolation to compare two or more economies. For example, if the US and Indian markets are compared just by the Buffett Indicator, it may seem that the Indian markets are reasonably priced and the US markets are significantly overvalued. But if you add the factor of the trillions of dollars of liquidity in the US markets generated by the economic stimulus packages to revive the economy, one may not be in a hurry to sell out of that market.

“There are times when due to a general panic sentiment in the markets, investors miss out on the logical thing to do which is capitalise on the opportunity of buying into cheap markets. This was evident during the Covid crisis last year. However, using tools like the Buffett Indicator, investors can make logical decisions. From running close to 100 per cent before the pandemic, the Buffet indicator fell sharply to 46 per cent in March 2020, indicating much more damage in sentiment (due to emotional factors) than in actual GDP figures. The decline showed that our markets were cheaply valued, but many ignored this and actually sold stocks during that time, and missed out on the surge that happened later – a lesson learnt not to ignore scientific tools like the Buffet Indicator especially in times of panic,” he says.

Buffett Indicator and Your Investments

With market valuations hovering above the long-term average zone, investors should avoid putting lumpsum investments in the near term and phase out their investments – by way of SIPs in mutual funds, says Mullick. The medium-to-long-term has always looked good for our markets, so continue increasing the amounts of your monthly SIPs and stay invested for as long as you don’t need the money.

Srinivasan, however, warns investors to remain cautious. He says the Reserve Bank of India has also clearly issued a warning to investors of an imminent bubble, highlighting that the stock prices have steeply increased while the GDP is likely to have contracted by around 8 per cent during 2020-21. According to Kamath, the investor should always tread markets with caution as short-term rallies and rebounds are always misleading. “Investors should have a strong narrative for any investments they do. We may not know where the company stock price will move, but we ought to know where it stands in valuation and growth prospects,” he says.


vishav@outlookindia.com

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