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Commentary

Are we at a Tipping Point

The big read of the week has to be the “Howard Marks” Memo which these days seems to be the second most read fund manager report after the Oracle of Omaha. In this Memo, Howard warns about the Risks that the market seems to be ignoring as the fear of missing out (FOMO) seems to drive money towards ideas that in general times wouldn’t have been given a second thought.

Last weeek, I ran a Twitter poll asking if it was possible to see 20,000 on Nifty 50 by year 2020.


Quite a few replied saying that they felt the chance was ZERO while the majority of voters felt that the chance was less than 25%.

The results weren’t surprising to me given that in recent times, there has been quite a concern that markets may have over-extended and it was time for a pull back. Yet, given the fact that we don’t know the future, should we write off even the remotest of possibilities?

No one really likes Bear Markets. While Value Investors claim to love Bear Markets as they provide them the opportunity to pick Dollars for Nickels, when the push comes to shove, I do wonder how many will be left standing let alone participate by buying stocks as they become cheap.

Bear markets come in different shapes and forms.

The 2000 Boom and Bust

Who doesn’t know about the Dot Com Bubble these days. December of 1998 was the start of the rally that took Nifty 50, a Index that wasn’t having any heavy weight Infotech Stocks at that time from 817 to a final high of 1818 in the space of just 15 months.

The rally in the Infotech Sector Index took quite a different route with the rally starting two years earlier in December 1996 with the Index floating around the 78 mark. When the peak was finally achieved, the Index was quoting at 9,550.

Similar to the Nasdaq 100 which took more than a decade to break its all time high of 2000, Nifty IT too broke its 2000 high only in 2013.

One thought process of where one should start a new bull rally emphasizes that a new bull rally starts only on breaking the previous all time high. Using that definition, we are still in the Infant stage of the bull rally in  Infotech (validity to remain as long as it trades above the 2000 high) and yet IT stocks are a pretty hated lot.

Nifty 50 on the other hand took around 34 months before it broke above the 2000 high and 48 months it was before we were well and truly above that high water mark. Dow Jones Index on the other hand had to wait for 72 months before the 2000 high was broken only for the financial crisis to crater the Index well below even its 2002 low (Nifty 50 on the other hand didn’t really come anywhere close to the lows we saw in 2002).

Its another matter that the stocks of the next rally bore little resemblance to the stocks that mattered in the earlier rally.

The 2004 and 2006 Mini Bear Markets

Markets fell greater than 30% from their peaks in 2004 and 2006, but given the speed of recovery, this mini bear market is less talked about. While the trigger to the 2004 fall was the surprising end to the NDA government in which markets had great hope, the 2006 fall was triggered by global factors.

While both 2000 and 2008 are talked about as the great bear markets, 2004 and 2006 aren’t since the amount of time spent underwater was fairly short. Markets rebounded strongly from the lows and in no time were we back at the earlier peaks.

The Great Crash of 2008

Who needs to be told about the crash of 2008? These days, every time market starts to feel a bit too hot, the fall of 2008 is what comes to top of the mind. Investors who look at valuation seem to worry that every time we close in to the valuation we saw in 2008 prior to the fall, its just a matte of time before we see a repeat of the same.

At its peak, the much derided and yet the quickest way to figure out where the market lies, Nifty 50 PE was testing the highs it saw in 2000. Sensex PE Ratio (both of them being at that time of 4 Quarter Trailing Earnings on Standalone Balance Sheets) was a bit away from its peak of 2000.

Despite the difference in stocks (Nifty 50 has 51 stocks while Sensex has 30) and the weights, both most of the time top out simultaneously most of the times. 2008 was one such instance.

The fall of 2008 has for many who experienced the same has created a phobia of every fall being similar to the one seen in 2008. Seeing your retirement kitty (if invested in the market) fall by 50% or more is nothing some one can forget in a hurry.

For long, Foreign Institutional Investor have been the critical driver behind the rise and fall of markets. Other than for the one instance of 2016 where markets closed positive even as FII’s sold (Calendar year basis), every time, FII’s have sold, markets have dropped and vice versa.

Much has been said about how Mutual Funds are becoming the key driver in markets. But a cursory look at the Quarterly net flow of Equity Mutual Funds doesn’t really show it likewise. We have had similar inflow’s in 2007 for instance as we are having now.

The only difference is in terms of Gross Inflow / Outflows. While the first 6 months of 2007 saw a Gross inflow of 42,903 Crores , in 2017 its 1,24,517 Crores. This would suggest that while there has been a strong move towards Mutual Funds, the churn is pretty high as well.

Breadth Indicators

One way to determine where we are relative to earlier times is to look at a few breadth indicators.

Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”

John Templeton

A euphoric market is one when literally everything is flying. At this point of time, you don’t need to do any Analysis but just invest in anything that seems to be moving higher.

While Mid and Small Caps seems to have been in a Euphoric in recent times, the evidence doesn’t easily lend to that buzz. For instance, here is a chart which plots the percentage of stocks that are trading above their 200 day Moving Average.

The above chart contains 2 data points. The top pane plots Nifty along with the 10 day Moving Average of Number of Stocks trading above the 200 day Indicator. The idea of using a 10 day Average is to smooth out the volatility.

The lower pane provides the raw data – % of stocks trading in NSE that are above their 200 day averages.

At 60%, we aren’t really into territory that seems to be risky at the moment. In fact, post 2014 Election Rally, we haven’t seen the Indicator cross 70.

This in my opinion is indicative of the fact that markets aren’t totally over-bought. While one cannot rule out any reactions from current levels, any major bear market of the kind seen in 2000 or 2008 seems to be not on the cards unless there is a Global Meldown in Equity in which case, all bets will be off.

Valuation

The big elephant in the room would be Valuation. Markets are expensive based on PE Ratio regardless of what Index you apply the same upon. The only cheap Indices would be the Infotech and Pharma, but hey, who wants to invest there in the first place.

Above is the Nifty Price Earnings Chart over time with Average and Standard Deviations. A casual observation would be that while markets are expensive, they haven’t reached a point where the odds really aren’t in favor of exposure to equities.

Current market valuation is more expensive than in 2004 prior to the crash, but is the Index the same as what was in 2004? Currently Financial Services account for 35% of the total Index weight. This wasn’t the case in 2004 for instance when the composition of the Index was vastly different.

Only 25 stocks continue to be part of the Index when one compares the Index of 2004 to that of today. In other words, as much as its essential to look at historical data points to get a sense of valuation, ignoring the huge churn and differential weights can change the basic structure of the analysis.

HDFC Bank for example is trading at 30 times its earnings and is closing onto representing nearly 10% of the Index weight. A High PE + High Weight in turn would pull up the overall weight of the Index. Is HDFC Bank cheap or expensive is another story altogether.

The path forward

Wouldn’t it be lovely to have a Almanac which can give us precise turning points of the future (Experts of GANN, a style of Technical Analysis would love to claim they know such dates) so that we can be fully invested when markets are trending higher and be totally in cash when the trend turns to bearish.

While we cannot project the future, one thing that is bound to showcase the future as it happens is the chart. Right now, the market is strongly bullish regardless of what method you apply. At some point markets would start to roll over breaking major supports and trend-lines on the way. That would be a better time to become bearish than try to predict the top based on tools that fit our narratives.

Above chart is as on date. Compare this with similar chart of the previous bull run. See something similar?

Is the chart of 2017 similar to one of 2008 or are we placed similar to 2006 or 2004?  Once in a while markets can go up sharply at a 45 Degree Angle. While they mostly end up correcting, not all corrections end up like 2008.

I for one continue to believe that the best way to play would be to follow a Asset Allocation mix that is suitable under current circumstances and one while allows us to reach our goals even if the best laid out plans falls flat.

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