A Decade is a Rather Long Time!

8^th 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 10^th 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!