8th January 2008 was a
watershed moment in the history of Indian financial markets. It was on this day
that the Nifty made its major top after rallying by a monstrous 500% since the
start of 2002. Similarly, the S&P 500 rallied 95% between Jan-02 to Dec-07
and then fell by a whopping 60% in the ensuing months. We are now in the 10th
anniversary of the worst ever financial crisis which the world experienced
since the Great Depression of the 1930's. The scars of the crisis are still
etched vividly in the minds of the investing community. In fact, it has significantly
altered the way policymakers and investors think about the economy, recognising
the important role that financial frictions play on the functioning of the
business cycle.
Fast forward 10 years and most global
markets are now making new highs. In fact, the S&P 500 is up a massive 72%
from its previous 2007 peak while the NIFTY has also registered similar gains
during the same period. This brings us
to the question - what have been the similarities and dissimilarities of the
current bull-run vs. the previous? Are two bull markets always the same?
The common thread between the
last market peak and the current highs appears to be stretched valuations.
Global market cap to GDP reached ~100% at the end of 2007 before declining
sharply as the financial crisis hit. Global market cap once again stands at
~100% of GDP (Chart 1) and most markets are currently trading at the top decile of their
respective long-term one-year forward P/E history.
Chart 1: World Market Cap (% of GDP) back to 2007 levels
However, this is where the
similarity seems to end. A defining feature of the last bull-run was
synchronisation. This synchronisation occurred at two levels:
- Global Business Cycle Synchronisation: The opening up of world trade and China’s accession to WTO at the end of 2001 created a virtuous cycle which helped improve productivity levels across all major economies. The result was that the business cycle of most economies got aligned with potential growth increasing together in the first half of the previous decade and getting bridged together in the latter half of the decade. The biggest reflection of this came in the form of convergence of monetary policies with all major central banks cutting and raising rates in tandem
- Business and Market Cycle Synchronisation: As the global economy grew at a robust pace thanks to trade openness and productivity gains, it translated into revenue and earnings growth worldwide. This in turn propelled global markets higher. Notwithstanding the excesses that got built into the financial markets towards the fag end of the bull-run, a large chunk of the market returns in the previous decade were backed by strong economic fundamentals.
While synchronisation was a major
characteristic of the last bull market, divergence seems to be the name of the
game of the current rally. Firstly, business cycles appear to have become
misaligned – US looks like a late cycle economy, Euro area appears to be a
mid-cycle economy while most Emerging markets are in the early to middle stage
of an economic recovery. This divergence
is once again well reflected in the conduct of monetary policy – while Fed is
well into the hiking cycle, the ECB and BoJ continue to ease.
Not only have business cycle
diverged, but financial markets too appear to have become disconnected from the
business cycle. Never ever in the history of financial markets have this kind
of disparity been seen between the financial economy and the real economy. While
2017 has only been the first year of a broad-based global profit recovery –
most equity markets have already hit new highs. Thanks to the liquidity
super-nova courtesy the major central banks, equity markets appear to have
borrowed too much from the future.
A few other discrepancies between
the last and the current bull-run include performance of asset heavy vs. asset
light models. The last cycle was all about capex while the current cycle has
been all about consumption. It is therefore not surprising that the market cap
of FAANG+BAT now exceed the entire market cap of Germany! Similarly, trade
openness was a big theme of the last cycle while protectionism has gained
significant ground in the current cycle. Above all, the political landscape has
undergone a massive change all across the World. After all, ten years ago who
could have imagined that an eccentric TV show host would go on to become the
President of the United States of America or British political leaders would be
negotiating for an exit out of the Euro zone.
Surprisingly, nowhere have the
divergences been as acute as they have been in India. For instance, most of the
macro data points currently suggest that the Indian economy is in the early
stages of a cyclical recovery – capex to GDP, profit to GDP, credit to GDP and
inflation are at cyclical lows. Yet most of the indices are sitting at new
highs with frothy valuations that are generally observed towards the fag end of
the business cycle.
This sharp divergence between the
real economy and the financial economy means that we are likely entering a
phase where the tussle between bottoming fundamentals and sky-high valuations
would certainly lead to higher volatility. Indeed, the absence of volatility in
the markets specifically in the last few quarters is also unprecedented.
What is even starker is how
dramatically the composition of the market has changed between the last
bull-run and the current. This is highlighted in the table below:
Table 1: Sectoral Composition of BSE 500 Index
The above table clearly shows the
large adjustments which the market has undergone in the last ten years. The
share of the so-called “old economy, capex driven, asset heavy” sectors have
shrunk massively, while consumption driven stocks (consumer NBFCs, consumer
discretionary, consumer staples, etc) have gained at their expense. This is not
surprising. The 2002-2008 business cycle in India was led by capex while
consumption share in GDP declined precipitously. On the other hand, the current
cycle is the first in last many decades, where the share of consumption in GDP
has actually increased.
Market changes are constant but
very difficult to predict. At one hand, no one would have envisaged the kind of
changes that has happened over the last decade. However, the fact of the matter
is that these changes if caught at the right time, give tremendous opportunity
for alpha creation. For instance, the Nifty is up 75% in the last 10 years,
where as many sectors and companies which aligned themselves to the macro
changes have risen by multiple times.
We acknowledge that predicting
how the aggregates would shape up is a daunting task. But it’s also true that
macro/sector/theme rotations are permanent features. No two bull markets are
ever the same. The winners of the last bull-run may very well turn out to be
losers of the next. The above particularly holds true for the Indian economy.
India by virtue of being at a nascent stage of its development cycle keeps
undergoing rapid transformation from time to time. For instance, formalisation,
financial inclusion, supply-side reforms and digitisation are some of the
changes that the economy is currently witnessing. These changes will ensure
that our market composition keep changing rapidly. This in turns provides a
tremendous opportunity for active asset managers to beat benchmarks. What's
critical is to find "where is the sweet spot"? Getting the rotation
right and early is the key!
