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How inflation can end the equity market dream run?

When the booze is overflowing non-stop in a party riding on high octane, very few drinkers really think about the consequent hangover when the party stops. In such a high adrenaline atmosphere, many grossly overestimate their capacity to drink, encouraged by behaviour of their friends & crowd around them.

The world markets are going through a similar party. The booze (easy money) is supplied by central bankers all over the world in high quantity and they promise they won’t stop anytime sooner.

The heady cocktail of easy money has been keeping the party going on for a long time. Emboldened by the recent successes in the equity markets where liquidity has lifted all the boats, many investors are doubling down on their bets by overestimating their ability to absorb losses. Many believe that the possibility of losses is very minimal since the central banks are on their side.

To quantify, the Central bank of the USA – Fed printed more than 20% of total US dollars ever printed in the last year.

Super loose monetary policy also encouraged many countries & companies to go on a debt binge. The debt as a percentage of overall GDP has risen sharply.

Low interest rates have also played a major role to push people towards speculative asset classes. And so far, the majority have seen the value of their investment going up only in a very short span of time without much downside volatility. Investments in cryptos, equity, and other speculative plays are seen as get-rich-quick schemes and so far, no one is complaining. World markets in some manners resemble casinos.

The rapid money printing and low-interest rates have made many people rich and consequently happy. Why then central banks never did such a thing earlier which can make so many people wealthy. The newly minted wealthy and consequently happy population will obviously love the Govt policies and will continue to vote for the same set of politicians. Isn’t it the simplest and brilliant idea for politicians to forever stay in power? They didn’t do it for a simple reason – Inflation.

Why you should worry about inflation if you are investing in the equity or debt market? How inflation can end the equity market dream run? To understand this, one needs to go not very far in the past. The economic scenario during the 1970-80s serves as a good reference point.

The world monetary system was linked to Gold for a very long time. This means the amount of money printed should be backed by gold. In 1971, the link of money printing to gold was completely broken and the era of fiat currency began. This gave central banks the power to print as much money as they like without any restriction.

The US followed an ultra-loose monetary policy by keeping interest rates low and by printing money. That resulted in temporary low unemployment and higher economic growth. Buoyed by the success of new monetary policy thinking, people re-elected their president – Richard Nixon in 1972.

Within a few months after the elections, inflation more than doubled to 8-9%, thanks to the easy monetary policy and support from a sharp rise in oil prices. Later in the decade, it would go to 12%. By 1980, inflation was at 14%. To curb inflation, interest rates were raised to close to 20%. Equity market index – S&P 500 which went up until 1972, enthused by the new monetary policy, crashed by 50% over the next two years. The next 10 years annualized returns on the index were negative 9% (Index Value: Oct 1972/Aug1982 – 761/301). Unemployment shot up to 10%. Rising interest rates caused a calamity for interest-sensitive industries, such as housing and cars. Naturally, millions of Americans were angry with the Government by the late 1970s.

Here is the simple economic logic – if the rate of money printing is higher than the rate of production of goods and services in an economy, the prices will increase. In simple terms, if you have x amount of money today and it becomes 2x tomorrow due to excessive money printing keeping the rate of growth of goods and services at zero, then what you could purchase for x earlier, you will have to eventually spend 2x to purchase the same amount of thing because of the impact of inflation. Higher demand, fuelled by excess money, without similar improvement in the supply side results in a bidding war that takes the prices of goods and services higher. Thus, in reality, even if your money is doubled, your purchasing power remained the same. The value of money has just gone down by 50%, leaving you in the same economic state as earlier.

Poor suffer the most from the impact of inflation since they have very low exposure to assets whereas food & fuel accounts for a major part of their household budget. Politicians cannot afford to keep so many voters unhappy and they try everything to bring down inflation or else they risk losing the public support.

Learning from the failure of America’s “path breaking” monetary policy of the early 1970s, the policymakers understood the importance of maintaining the fiscal discipline to prevent long-lasting inflation and its disastrous effects.

However, this fiscal discipline was thrown out of the window in 2008 after the subprime crisis. Led by US Fed, many central banks printed huge amounts of money, more than doubling their balance sheet size in a few years. They were warned by the economist that this could result in higher inflation. But due to various factors like rising investments in shale gas, global manufacturing shifting to China for their ability to produce goods at low cost, aging demography and productivity gains from technology helped calm the price pressures. Moreover, the money printed was disbursed to the banks and financial institutions that invested the surplus to capital markets.

This gave confidence to central bankers that money printing will not result in higher inflations. Before the covid struck, the central banks were trying to reduce their inflated balance sheet and increase interest rates. However, when the corona-led economic shutdowns happened, the central banks ran their printing machines at full capacity. Consequently, the prices of many commodities and services started rising, due to higher demand and supply-side disruption.

Some of the widely used commodities and their price movements:

Commodities index hits the record as world rebound meets shortages.

All the economies are getting affected by a sharp rise in inflation. In India, commodity inflation has been denting the profitability of consumer companies. Asian paints recently reported 29% YoY profit decline in its Q2 FY22 results. The reason management gave – “unprecedented inflation” like we haven’t seen in the last 30-40 years.

Central banks are maintaining that the current bout of inflation is transitory. However, it may not be transitory as earlier thought of due to the following reasons.

–          Manufacturers moving out of China for regional diversification lead to increasing costs of production of goods. China is also facing an energy crisis and a shortage of goods. Factory price inflation in China is running in double-digit.

–          Compared to the money printing in 2008 which went to the banks, this time many Americans have also got money directly in their bank account

–          The pace and quantum of money printing has been excessively high

–          Wages have started rising faster in many decades due to shortage of labour as compared to the number of vacancies

–          Significant investment shift towards sustainable energy sources resulted in Greenflation i.e., rising prices for metals and minerals such as copper, aluminium, and lithium that are essential to solar and wind power, electric cars, and other renewable technologies.

If inflation continues to rise for a longer time, central banks will be forced to increase the interest rates to curb inflationary expectations. The rise in interest rates will increase the cost of owning equity resulting in a fall in equity prices. Higher interest rates will lead to heavy mark to market losses on long-term debt papers and could lead to contagion in all the asset classes which have been inflated by massive systematic liquidity.

Remember the taper tantrum of 2013? At that time equity markets and debt markets went down sharply due to fear of reversal of loose monetary policy. Now the value of equity and debt is almost 50% higher as a percentage of world GDP as compared to 2013. What will happen to the markets if the central banks decide to begin the end of easy monetary policy?

Now the important question is how to protect our portfolio from severe decline if inflation doesn’t turn out to be temporary and force the hands of the Central banks to raise interest rates.

Our simple advice – maintain equity exposure in your portfolio to the extent where a 50-60% fall won’t affect your peace of mind. For debt allocation one can consider short maturity portfolios like ultra-short-term, low duration, or floating rate funds. Having a 15-20% allocation in Gold could also help in times of hyperinflation. You can read more about the significance of gold allocation here and about asset allocation here.

Nobody knows when the music at the stock market party will stop.  But we all are certain about this one thing – bigger the party and the cocktail consumption, bigger and worse are the hangover effects.

Truemind Capital Services is a SEBI Registered Investment Management & Personal Finance Advisory platform. You can write to us at connect@truemindcapital.com or call us on 9999505324.

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Where do we stand in the equity market cycle?

Sentiments of greed, fear, and confusion are transient in the equity market. The sentiment cycles are permanent.

Most of us have come across the following chart of the sentiment cycle. For those who are uninitiated, the below chart represents the cycle of greed and fear in any asset class with varying degrees of emotions.

Sentiment cycles move from one extreme of greed to another extreme of fear which takes valuations also to extremes from their long-term averages.

At the extreme of greed sentiment (which coincides with steep valuations), the risk-reward ratio of investments is highly unfavorable i.e., lower potential upside with higher potential downside risk.

At the extreme of fear sentiment (which coincides with dirt-cheap valuations), the risk-reward is highly favorable i.e., higher potential upside with lower potential downside risk.

In this blog, I am attempting to understand where do we stand in the current market cycle.

In my previous blog on market cycles, I highlighted the following 5 observations during market peaks:

Retail participation is huge. People with very less knowledge about stocks and most risk-averse FD investors start putting money in equity markets.

Newspaper headlines scream with euphoria about new peaks achieved by markets (and prediction of higher peaks).

There is utter rejection/ridicule of thought or statement that markets can decline by more than 20%.

The majority of the stocks start trading at valuations much above their historical averages.

A melt-up rally (usually more than 50% from the lowest market level in the last one-two-year period).

Now, let us see how many observations points we are checking currently.

Observation 1

Huge Retail Participation: This is something we all have observed in our circle over the past few months. Many of our friends, colleagues, or neighbors who have always preferred FDs and safe investment options have started investing in the stock market – either directly or through mutual funds.

A lot about it has been written in news with data on the surge in new demat/trading accounts being opened in the last 1 year. Some people who were earlier in jobs have now become full-time traders.

According to the industry data, retail participation in stock market trading has gone up from 33% in FY16 to 45% in FY21.

Not just equity, a huge participation of retail can be witnessed in speculative assets like futures & options, and cryptocurrencies to name a few.

Thus, we can safely say, the first point is checked.

Observation 2

Newspaper headline scream with Euphoria: Any regular reader of the business newspapers can validate that the news of strong bull run and predictions of the market achieving further highs are quite regularly over the past few months. Here is the front page of Economic Times, 1st Sept 2021 edition.

Do I need to say more? So, this checks our second observation point.

Observation 3

Complete rejection of any thought of market correction: Relentless market run creates a recency bias in the minds of many people. They assume that the trend over the last few years will continue and any major correction in the market is a distant possibility. That’s why many investors prepare a trap for themselves as any minor correction is looked like an opportunity to invest more and overexpose the portfolio to already expensive valuations. Sometimes, what is considered to be a minor correction snowball into a major correction, and then there is nothing left on the table to take advantage of extremely cheap stock prices.

I used to hear from investors before the covid crash last year that 20% correction is not possible (and that actually didn’t happen for almost 4 years) and I am hearing the same over the past few weeks.

If one has to look at the PE ratio graph, there is an absence of volatility on the downside from long-term averages since 2016. The trend only briefly got disturbed for a few months last year. If we see the period prior to 2016, there was good enough volatility in the market around long-term averages which is how markets normally behave.

Observation 4

Extreme Overall Market Valuations: Market valuations are expensive is very common knowledge now. Though, some might not be knowing how expensive they are and others justifying the case for sustained higher valuations.

Let me share some valuation metrics to get a sense of high expensive today’s markets are.

a) Sensex is currently trading at 30x TTM (trailing twelve months) PE multiple, much above its long-term average of 19-20X. Any investments that are done in Sensex at PEs of more than 25x have delivered abysmal returns even over a 10 years horizon.

b) P/BV multiple is at the highest level in the last 13 years.

c) Indian equity market is the most expensive in the world.

d) Global Market cap to GDP ratio is at a record high. All the observations at market peaks are not just for the Indian markets but it’s a global phenomenon. The global market cap to GDP ratio is the highest in the last 20 years.

Aggressive money printing by central banks has inflated many asset classes all around the world.

Bank of America has projected negative returns over the next 10 years on US Equity Benchmark Index – S&P 500 owing to expensive valuations. You can look at the forecasted return vs actual return till 2011.

Global markets are very closely intertwined with each other. Any decline in US markets will have an impact on all the equity markets globally.

Observation 5

A melt-up rally: The Indian equity market is up 124% from its March low last year. Past two bubble bursts have been preceded by a sharp melt-up rally. How far it will go before the burst is anybody’s guess.

We are mostly checking all 5 observation points which are indicative of market peaks. The observation list is definitely not exhaustive but captures some of the most common key parameters.

Although it is very difficult to put a finger on exactly where we are in the market cycle, my best guess is we are in the zone of euphoria.

Many of us nod in affirmative to the logical sense of investing in the market cycles but most of us continue to invest and not reduce our equity exposure when markets are extremely expensive.

Why most of us do not follow the logical steps of buying low and selling high as represented by market cycles? Why do the majority of people end up investing at high market levels and exit at low market levels? Because we tend to think that emotion of greed & fear affects others and what we are doing makes perfect sense at the moment. And also, the majority of us lack the patience to implement logical investment plans with discipline. Without patience and discipline, long-term investment success is just a mirage.

Unfortunately, emotions of greed and fear of missing out (FOMO) are so strong during a relentless market rally, especially when our friends, neighbors, and strangers are sharing how they have made quick money from the stock market, that our mind starts justifying getting on the bandwagon. Our emotions possess our minds at extremes, take over our ability to think logically and we justify our actions of investing with such reasons:

– The market will not fall. Even if it does, it would be a minor correction and we will be back on the uptrend.

– I am investing for the short term and when I will sense a correction, I will exit immediately.

– This time it is different. High market valuations will sustain for a long time to come.

– I am in for the long term and not bothered by minor short-term corrections.

These are the exact reasons given to justify investing during every market peak and before every market crash.

“History does not repeat itself but it does rhyme.” Mark Twain.

Please note that when we say the markets are in a very expensive zone or closer to their peak, it doesn’t mean that it will correct sooner or it won’t get more expensive. Markets can continue to remain expensive for a long time and reach more dizzying heights. The key point is that any investments at current market valuations have very limited upside potential but very high downside risk.

And guess how many could successfully exit at the very top every time – I am yet to find that person. Perfect exit is an illusion we entertain by overestimating our abilities to time the market. Those who believe in a perfect exit, I wish them good luck.

For others, it’s important to follow a tactical asset allocation plan with utmost discipline to protect the portfolio on the downside and enjoy the upside returns.

Truemind Capital Services is a SEBI Registered Investment Management & Personal Finance Advisory platform. You can write to us at connect@truemindcapital.com or call us on 9999505324.

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