BT Insight - Are equities heading for a larger correction?

There are many who feel relieved that a large part of their losses during the recent crash have recovered now. However, many others have a fear of it being a false recovery driven more by hope and less by ground realities.

The year, which had a stupendous beginning for the equities, turned into a nightmare within a month and witnessed the worst ever correction owing to COVID 19. While people were still struggling to come to terms with the new reality and looking for ways to adjust, the extraordinary pace of recovery of equities has left many bewildered as what this astronomical correction was all about.

While many investors already exited with the first opportunity, there are others who are here for long haul and worried about the safety of their investment. As the future direction of equity market is swinging between bear and bull, we examine how real the fear of this correction is and should investors adjust the equity portfolio accordingly?

The symptoms of fear

Sensex registered a sharp recovery of 51% to 39,303 till September 16 from its bottom of 25,981 registered on March 23. However, since then it fell again by 2,749 point to 36,554 till September 24. It regained 835 points on Friday and closed at 37,388.66.

The fear of correction has been accentuated by record outflow of Rs 2,480.35 crore and Rs 3,999.62 crore in the month of July and August from equity mutual funds, respectively. This has reflected in the overall position of the DIIs in the equity market.

"Equity markets work on flows. There are broadly three sources of flows in Indian markets, viz. domestic institutions, foreign investors and retail. Since May, both FIIs and retail investors have been buyers. However DIIs have turned sellers since July. If there is a change in this balance, there could be a correction. Already in September, FIIs have turned sellers, which has to be watched," says Sameer Kaul, CEO and MD of TrustPlutus Wealth Managers (India).

Is recovery a mirage created by too much liquidity?

Central banks, world over, have been pumping money to save their economy. Case for individual investor is no different. Interest rates have touched a record low, the return prospects in real estate are not looking very promising, and gold has lost the momentum and has been on correction spree after going above Rs 55,000 per 10 gram. So, what are the investment options left with investors? For a large number of investors, equities are the only hope. Hence, a greater pie of investors' surplus is getting channelised to equities.

Globally too, the fund flow follows the pattern. "There is definitely a lot of liquidity. But more than that, the ultra-low or Zero Interest-Rate Policy (ZIRP) is an even bigger problem. That distorts the relative valuations between different asset classes. Investors find it difficult to define what is an adequate risk premium they need from other asset classes relative to the risk-free. Everything seems better than zero. This encourages capital flows to potentially higher return, though riskier asset classes, such as, emerging markets," says Vikas Gupta, CEO Omniscience Capital.

When compared to quantum of global fund, there are very few stocks in emerging market that have capacity to absorb a good amount of liquidity. "From within this limited universe, there are still fewer with high predictability in terms of strong fundamentals and growth. Hence, these start getting higher and higher prices creating a price momentum and self-reinforcing cycle which attracts more investors chasing these stocks. Eventually, this has to result in extreme overvaluation. But the ZIRP situation forces the investors to accept these ultra-high valuations, as seen in Indian FMCG and so-called "quality" stocks, since they think that the fundamental growth will bail them out," adds Gupta.

However, a look at the top 500-listed companies of India tells a different story about the distribution of this liquidity."If we look at the NSE500, the top performing 227 stocks have gained 50% or more, as compared to the index which has gained 40% in the last six months. This period also coincides with the bottom formed on 24th March this year. Therefore, it is clear that liquidity has found its way into a large number of stocks, and not just a select number of stocks," says Kaul.

While the participation has been broadbased, the quantum of inflow is skewed towards the larger players. "The question is volume. Naturally a mega cap stock like Reliance or TCS can absorb a lot more than a small cap stock. To that extent, it is evident that more money has gone into the top liquid stocks on the exchanges," says Kaul.

Are equities over-valued?

The next question is whether this excess liquidity is finding its way to the stocks resulting in overvaluation or not? "Valuation of any asset is the function of demand and supply which is derived out of the fair value assessments of buyers and sellers. Fair value is a function of intrinsic value and speculative value, which is driven by liquidity. Hence in a scenario when liquidity is high, the financial assets tend to get into overvalued zone. This is the current situation," says Vivek Bajaj, Co-Founder, Stockedge.

Is this liquidity fuelling artificial hype of valuation or has some sound reasoning. "The headline Nifty50 Index is still trading at a premium valuation, which is led by Reliance, IT majors and healthcare companies. These businesses have actually gained due to Covid, which could be a reason for this premium" says Kaul.

While the large-cap index is appearing to have return near its peak, the broader market is yet to recover completely. "The broader Nifty 500 Index is already at the same level as it was three years ago, so in effect the broader market already recognizes that we could potentially have the same earnings in FY21 as in FY18. Within this mix, there are companies which are overvalued and those which are undervalued," adds Kaul.

When it comes to valuation of global equities, a comparison from the Indian equities shows they are relatively undervalued. "From our recent report "From the Mythical Bubble into a Vacuum", the PE of US Tech sector index is 24 while the Indian All cap index is at 38 and Indian FMCG index is at 39. So the popular Indian stocks are much more overvalued compared to the large, very well-known, popular US tech stocks. Most of these seem fairly valued given the risk-free rate and their large growth rates going forward. Compared to the popular Indian stocks they appear cheaper, as well as, enjoy potentially higher growth rates," says Gupta.

So, if some investors find the Indian equities overvalued, it could be a right opportunity to diversify their investment into international stocks where valuation is still on the lower side.

Is capital market disconnected from economy?

Should capital market be just a reflection of state of economy or should it look ahead? "We have been taught by various text books that Stock market is the barometer of economy. However, we were not told which phase of the economy. Are we talking about past, present or future? We have also been taught that stock valuation is the function of future performance of the company. Thus, the best judgment will be to assume that stock market is the barometer of the future performance of the economy," says Bajaj.

The market rather than looking at current suppressed earning is looking at the earning potential of future when business returns to normalcy. "So, in short term there is a disconnect due to high liquidity available globally as interest rates are very low, but in long run as markets will eventually follow the

fundamentals, the mean valuation will be restored. I believe currently market is expecting a major recovery in economic activity in near future," says Bajaj.

Another factor which is playing predominantly is that it's not a normal disruption but a situation which will witness a complete realignment of global businesses. It's just the beginning of the new order. "We should also not forget the ZIRP and the global supply chain rearchitecting away from China attracting large FDI. So the economy will survive and probably thrive. But an investor in the BFSI sector, i.e. a shareholder of a lender, might not be the happiest person as his capital might get eroded in the near-term as discussed earlier," says Gupta.

Is BFSI the future landmine?

While government can afford to forego its revenue but for lenders, it is not a matter of choice as they incur cost on funds for each passing day. If a large number of borrowers start defaulting, the BFSI sector which is known to be growth engine of the economy cannot sustain.

"The Covid lockdown had created difficulty for many of the borrowers hampering their repayment capacity. For some it was temporary and for some it is permanent. The moratorium and restructuring of repayments is good for those whose repayment capacity was temporarily hit. In fact, the moratorium saves, both, the borrowers and lenders, as far as this category is concerned. If there was no moratorium and restructuring they would have become NPAs and the lender would also suffer permanent loss of capital on something which was temporary," says Gupta.

However, the pandemic has not hit all businesses equally. Although most businesses have survived, there are some who are finding it difficult to operate. "For those whose repayment capacity is permanently destroyed, the moratorium is just kicking the can down the road. The lenders will have to absorb these losses and will definitely slowdown their future lending capacity and growth," says Gupta.

Will it hamper the ability of the BFSI sector to finance the growth of the economy? "The RBI and the Government of India have a lot of tools in their toolbox which they can bring out to kick-start the growth. So the economy will continue growing. In fact, it is likely that FY22 and FY23 might have much higher growth rates than normal due to lower base effect of FY21, pent-up demand during the lockdown, and fiscal measures from the GoI, like AtmaNirbhar Bharat," says Gupta.

Should you be adventurous or cautious?

While coronavirus was an unknown threat with unknown damaging capacity, the market went for an overdrive in correction. However, as the world now has fair degree of understanding of this pandemic and now limping back to normalcy, it now appears only a matter of finding the aftereffect.

"Recovery is with wide base with across the board every stock getting the benefit of the same. However, it is possible that some of the stocks showing signs of recovery in prices may not be in sync to the real business environment for that industry. Hence there could be mistakes. I suggest one should be very selecting in terms of identifying the right sector which is beneficiary in such environment," says Bajaj.

There has also been a polarisation in among the sectors which have been hit hard and which have come better off after the pandemic. "There are some hits, some misses and some evergreen stories associated with this question. Major hit has been telecom and pharma. Major misses are the financials particularly on the lending side. The evergreen story is the FMCG and consumer basket that has received strong impetus due to work from home syndrome," says Bajaj.

If you are long term equity investors, it's time to review and adjust your portfolio to the new realities rather than buying into the narrative of impending doomsday. The best way to find right stock to invest is to go for the business that you can easily relate to and understand. "At this juncture, investors should look at the businesses they want to own, and buy these at reasonable valuations. The volatility in markets is just an opportunity for long term investors who want to buy quality businesses and build long term portfolios," says Kaul.

This could also be an opportunity to find good stocks at cheap value. "It is better to allocate to a selected portfolio of companies which have strong balance sheet, persistent competitive advantages, i.e. supernormal profitability, and are available at significant discounts to their conservatively estimated intrinsic values; in short, what we call SuperNormal Companies at SuperNormal Prices," says Gupta.

The market sometimes is so sensitive that a small event can potentially snowball into big wealth destroyer. So, it is definitely not the time to throw your cautions away. "Sectors which are looking vulnerable right now are financials. There could be more downside, but in long term they will remain good bet for our capital hungry economy," says Bajaj.

When you have a stock about which you are not confident, you should take a call on exiting it based on its individual performance and growth potential of the sector. "I have a simple formula to exit any stock. If a stock goes below 15% of its 52-week high one should exit. An individual investor cannot evaluate the fundamentals of any company frequently. Price based action is the best theory that would work for retail because price speaks thousand words most of the time," adds Bajaj.

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