Speculative bubbles don’t grow on trees
An important question confronting Indian equity investors currently is whether we are near a mid-term market peak, and if a bear phase is lurking ahead. The Sensex has delivered a 22% return year-to-date, pushing the market’s trailing P/E (price/earnings) multiple meaningfully above the historical average, and prompting fears that India may have moved into speculative bubble territory.
History can illuminate some thought avenues but boundary conditions must be set first. It is futile to forecast a market correction of 5-7% (or even 10%) over a short period of, say, three-four quarters. One needs loads of luck to get this call—rather, guess—right. Indeed, for long-term investors there is more to lose by missing out on good stock opportunities than to gain from this often-ineffective urge to time the market. Second, if an investor is working with a time frame of at least two-three years, only then can this exercise—of trying to identify a speculative bubble and prepare for a vicious bear market—help.
A speculative bubble can be said to have formed when market participants’ psychology and behaviour drive markets to unsustainable levels from where there is a sharp decline subsequently. In most such instances, there is some fundamental thrust at least initially, which in turn transforms into a narrative of “new era”, “structural change”, or “this time it is different”. Slowly, the crowds put rationality to rest in their pursuit of supernormal gains in super-quick time frames, only to get mauled eventually.
Speculative bubbles are conspicuous but difficult to identify without the benefit of hindsight. Some key quantitative indicators regarding a bubble—or overheated, if not bubble—state of equity markets can be trailing performance of stock indices, valuations, and macroeconomic parameters. Then there are subjective indicators like liquidity conditions, and general investor and public sentiment. A quick analysis of the first two indicators (trailing performance of stock indices, and valuations) in a historical context delivers a decent understanding of how the market is poised.
Analysis of BSE (Bombay Stock Exchange) Sensex returns since 1979 suggests that at current levels the market is far from a bubble, or even overheated, zone. There have been 14 distinct peaks in one-year rolling Sensex returns since 1979. Trailing one-year Sensex performance at such peaks has ranged between 17% and 267%, with a mean of 79%. Currently, one-year performance (at 16%) of the Sensex is lower than all these mid-term peaks.
Similarly, there have been 12 peaks in three-year Sensex returns in this period. Currently (with 5% compound annual growth rate, or CAGR, over three years), we are not even close to a peak. The last such peak occurred in September 2016 (at 13% CAGR). The three-year trailing Sensex CAGR for these 12 peaks has ranged between 13% and 82% and has averaged 38%. Current Sensex CAGR, at 14%, looks healthier if we take the market pits of March 2009 as the starting point. On this time frame (rolling eight-and-a-half years), there have been six peaks since 1979 with CAGR between 14% and 41% and an average of 25%. Even here, the current one is the lowest peak since 1979.
At 24x, the Sensex P/E multiple based on trailing 12-month earnings per share (EPS) is the third highest seen since 1998 and is at a 29% premium to the historical mean. This may be an indicator of a possible bubble and even of an upcoming dip. Interestingly, the high Sensex P/E multiple here is ascribable less to a rapid market move and more to a lack of corporate earnings growth. At 3%, this is the second worst four-year growth phase for Sensex EPS CAGR in 15 years. The Sensex has been inching up causing valuations to dash ahead. To some extent, this re-rating can be linked to persistent low inflation and reduced volatility, apart from high hopes about macroeconomic and earnings trends.
Now, though it may sound counter-intuitive, speculative bubbles are uncommon in the absence of strong earnings growth or a solid macroeconomic environment, especially in the beginning of the rally. A case in point is the US market of 1920-29, which saw one of the strongest bull markets in history. The S&P composite index rose by 550% in the period but earnings doubled too. In many other bull markets too, like those in the US in 1932-37, 1942-46 and 1982-87, sharp market run-ups were accompanied by a healthy advancement in earnings. In India, the six Sensex peaks since 1998 witnessed an average of 13% earnings CAGR over trailing four years.
Finally, in all the notable bull markets in India in the last 20 years (1999, 2007, 2011), high P/E has been accompanied quite conspicuously by high P/BV (price/book value). However, at current levels, even as P/E has hit a peak, P/BV (at 3.0x) is 8% lower than its 20-year average.
The market is ahead of its fundamentals but does not seem to be in a bubble zone. P/E is inflated but market performance has been modest, P/BV is reasonable, earnings growth has been depressed, the macroeconomic fundamentals are mixed at best, and public sentiment still seems balanced between optimism and scepticism in varying degrees. History suggests that bubbles rarely form against such a backdrop. However, some market correction should not be ruled out assuming that P/E multiples regress towards the historical mean—it may even be in double-digit percentage, especially if earnings do not show signs of a revival in two-three quarters.
Vipul Prasad is founder and CEO of Magadh Capital, a long-only Indian equity fund based in Mumbai.
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