With the Dow effortlessly vaulting over the 13,000 barrier, there is no dearth of pundits quick to weave theories that explain why things could get even better.
One such voice is that of Jeremy Siegel, professor of finance at the Wharton Business School. In a recent article, Siegel said that US stocks could go up another 25%. His reason: The economic environment has become far less volatile in recent times because of better central bank policy on the one hand and a growing service sector, where output is less volatile than in manufacturing, on the other.
What Siegel means is that since the economy is less prone to violent ups and downs, there is less uncertainty, which allows investors to take on more risk.
It’s a thought also expressed by the Bank of England’s recently released Financial Stability Report, which says clearly, “Macroeconomic stability is encouraging greater risk-taking”. The report points out that fluctuations in GDP growth between 1990 and today in the US and the UK have been very low, with its measure of volatility coming down from 2-3 percentage points in the seventies to around 0.5 percentage points today.
It also says “the volatility of inflation and other economic indicators, both in these countries and others, have also generally fallen in what has been called the ‘great stability’.”
Volatility in equities and bonds in the US and the UK has also been lower in the period after 1990, compared to the seventies and the eighties.
The theory can also explain why debt has increased. There are many obvious reasons why people are borrowing more. One of them is because interest rates, particularly long-term interest rates, are in general lower than what they used to be in the seventies and the eighties. But it is also possible, as the Bank of England’s report contends, that the feeling that the downside is limited has led to banks lending more, because they are less worried about a severe downturn.
Central banks too can afford to take a more relaxed view. Hence their easy money policies and the higher levels of leverage in the global economy. For the stock markets, argues Siegel, a less unpredictable environment warrants a higher price-earnings (PE) ratio, which means that, even if earnings remain the same, stock prices should go higher.
There is yet another reason why PE ratios should go up. That is simply because interest rates were much higher in the seventies and eighties. The inverse of the PE ratio, or earnings/price, is also the yield on stocks and this should be at a premium to the yield on bonds, as investors are compensated for risk-taking. So if interest rates come down, earnings yield, too, will be lower, assuming the risk premium remains the same, which means that price-earnings ratios should increase. That will result in a rise in stock prices. And if the equity risk premium also declines, as a consequence of lower volatility, then stock prices should go up even further.
As we can see, it’s a nice and plausible theory that fits the facts and neatly justifies higher equity prices. Does it mean then the economic environment has altered so much that “this time it’s different?” Does it mean that “stocks have reached a permanently high plateau”? The problem is, that’s exactly what Irving Fisher, well-known American economist and author of a famous work on “The Theory of Interest”, said a few days before the crash of 1929.
Cynicism aside, what does the theory mean for Indian equities? One reason why Indian stocks have done so well is that earnings growth of companies has been exceptionally good. Return on equity for the Indian market is one of the highest in the region. But apart from earnings growth, part of the reason for the rise in stock prices has been higher valuations. A recent research note by Citigroup says that India is the most expensive market in the Asia Pacific region because on most of its valuation parameters, stock prices in the Indian market are well above their last 17 years’ average.
Yet, considering that GDP growth is now widely believed to have reached a higher sustainable level—nobody talks of growth being lower than 7.5% now—shouldn’t stock valuations, too, be higher, in terms of Siegel’s theory, because the downside is now limited? At the same time, the structure of the economy has also changed, with services occupying a larger proportion. The GDP is much less dependent on the monsoons than formerly. Put simply, growth is much less uncertain than it used to be. Under these circumstances, perhaps there’s a reason why Indian equities quote a higher price-earnings ratio than earlier.
The bears, of course, would lose no time in dismissing such theories, pointing out that “This time it’s different” is the most dangerous phrase in the history of investment. Many of them would say that the rise in stock prices reflects, not any fundamental change, but the deluge of liquidity that has been created by central banks around the world.
As for Indian market valuations, while it may be true that the economy has reached a higher growth level, that is true for China and several other economies in the region as well. Why then should India be the most expensive market among them?
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at firstname.lastname@example.org