This ratio is warning of a huge correction in stocks! - The 5 Minute WrapUp by Equitymaster
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This ratio is warning of a huge correction in stocks!

Feb 19, 2015

In this issue:
» India ranks low in maintaining fiscal discipline
» NDA government apes UPA in curbing fiscal deficit
» Has ease of doing business in India really improved?
» ...and more!

We all know Warren Buffett is not particularly big on making macroeconomic predictions. But once in a while he does seem to check the valuation of the broader markets. And at those times, he relies on his favourite metric known as the market cap to GDP ratio. As per Buffett, this ratio measures market values of all the listed entities in the US to its GDP. And is the single best indicator of where the markets are at any point in time.

However, those not particularly enamoured by this ratio have a choice in the form of another important ratio. Named after its founder, the ratio is called as Tobin's Q. And it denotes the total aggregate value of corporate America (the stock markets) in relation to the estimated aggregate replacement value of its stock of capital.

In other words, think of it as the price to book value ratio. The only difference being that the book value is not the accounting book value but the replacement cost of the tangible capital employed by a firm.

Intuitively, this ratio does make a lot of sense to us. An economy is indeed made up of firms where some earn returns more than the cost of capital while there are others that earn below their cost of capital. And therefore on an aggregate basis, companies should trade at valuations that are close to the aggregate replacement cost of their tangible capital.

As a result, if the stock markets are trading at a huge discount to replacement cost, they can be deemed as attractive. And if they are trading at a huge premium, they can be termed as risky and ripe for a correction.

Well, no prizes for guessing where this ratio stands at the moment. With the US stocks making one new high after another, this ratio has been bid up to dangerously high levels. And if a US fund manager called Mark Spitznagel is to be believed, this alone is the reason that a huge correction is round the corner.

Of course it can be argued that the US is now more a service sector driven economy and therefore, Tobin's Q may not be a correct reflection of over or under valuation of the markets. However, Spitznagel calls this as an erroneous assumption and argues that what's also true is that the US economy is more competitive than ever. And therefore, the transition to a service economy alone can't explain the high Q ratio.

As a result, Spitznagel has warned his readers to be ready for a significant correction in US stocks. Every time the Q ratio has been bid up to elevated levels in the past, a huge correction has followed. And Spitznagel sees no reason for the outcome to be different this time around.

Unfortunately, we are not aware of any reliable calculation of the Q ratio in the Indian context. And therefore can't really use it to understand the valuation of Indian stocks. However, on a price to book value ratio, we don't think there's a lot to worry just yet. The Sensex currently trades at a price to book value of close to around 3.1x. And if one tries to put this in context using data going back twenty years, we should start getting nervous once the ratio approaches the 3.5x-4x mark.

Therefore, while the Q ratio is warning of a significant correction in US stocks, India does not seem to have entered the zone of heated valuations just yet if the historical trend is any indication.

Worthwhile to add here that Microcap Millionaires, our recommendation service based on Benjamin Graham principles uses exactly such an approach to find out undervalued gems in the market. It aims to invest only in those stocks that are trading at a significant discount to book value and sells when the stocks are no longer look attractive from a price to book value perspective.

And how has this service done since inception? Well, despite being around 40% in cash, the portfolio is up an impressive 59% as compared to 43% returns given by the benchmark Sensex during the same period.

What more, we would soon be replacing some of our big winners in the portfolio with new stocks that are trading at a discount to book value and can give great returns over the next 1-2 years.

Which metric/ratios do you use to judge valuation attractiveness of stocks & markets? Let us know your comments or share your views in the Equitymaster Club.

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  Chart of the day
We just saw how Tobin's Q can be used to judge relative attractiveness of stock markets. While it is a valuation parameter there are various other economic parameters that global fund managers observe before buying into any country's stocks. Fiscal deficit is one such important metric that draws considerable attention among economists and investors alike.

Fiscal policy encapsulates government's measures pertaining to spending and taxation. If revenues are insufficient to meet the expenditure, government runs a deficit. Most governments run deficits purposefully to boost growth. As an example, if government spending is increased or if taxation is lowered (increases disposable income in the hand of consumers) GDP growth gets a boost. However, running huge deficit perpetually can lead to various problems.

As seen in today's chart, India's fiscal status is worrisome. In fact, it is worst amongst BRICS nations. Even Pakistan has a better fiscal record than India. If the government does not take immediate steps to curb the deficit and chases growth it may soon find itself cash strapped.

India's fiscal status is worrisome

Addressing the fiscal deficit problem will be the government's top priority in the coming Budget. And that it will in all probability. But the manner in which the concern will be addressed is a bigger problem. Now disinvestments have been the easiest leeway for the government to collect funds to bridge budgetary deficits. However, thanks to poor market conditions the UPA government met with little success in its disinvestment plans. The only year when the government had a windfall in revenue was the year of 3G telecom auctions.

The NDA government too seems to have had little originality in its plans to control deficit. Apart from the fact that oil prices have had a natural benign impact on deficit, the government can hardly take any credit. And now the blockbuster coal and telecom auctions are all it is banking on to get to a magical fiscal deficit number! Telecom companies have already submitted Rs 204 bn as spectrum auction earnest money to the government. And overall the government is expected to raise Rs 900 bn from the next round of spectrum auctions. That apart the sale proceeds from auction of 204 coal blocks is expected to fetch the government Rs 7 trillion! While several state governments will also have a share in it, the proceeds will certainly go a long way in helping the central government make the fiscal deficit numbers look a lot better.

But are these measures sustainable? And are we prepared to counter a situation where oil prices move back to higher levels? We certainly do not think so. So looking at the fiscal deficit numbers in the Union Budgets in isolation cannot be the best way to judge the government's competence in deficit management.

And it is not just investors but also India Inc that is increasingly getting impatient with the government. With loads of promises and tons on its plate, the government has hardly delivered much over the past 9 months. The NDA government won with an overwhelming majority and has formed state governments in several states. Despite that, the pace of reforms has been lackadaisical! And the big agenda by way of 'Make in India' and improving 'Ease of doing Business' seem to be losing steam. In fact, Mr Deepak Parekh, who was amongst the first corporate heavyweights to criticize the policy paralysis in the UPA regime, has come out strongly against the Modi government as well. The Chairman of HDFC group believes that 9 months is a long time for the government to not deliver. And corporates are increasingly getting impatient. Well, apart from the fact that corporates have little to look forward to, their earnings performance in recent months has little to write home about. And we have been telling this to you repeatedly. So without necessary and urgent policy actions, neither will corporate performance improve nor will earnings visibility get better. And in such a scenario, we will have investors, starting with the FIIs, quitting Indian stock markets in droves! You as a retail investor would do well to be better prepared for it.

The Indian stock markets are trading weak today. At the time of writing the BSE-Sensex was trading down by around 100 points, while the NSE-Nifty was down by 42 points. Losses were largely seen in power and banking stocks. However, most Asian markets were trading in the green at the time of writing. European stock markets, however, opened in the red today.

 Today's investing mantra
"What we learn from history is that people don't learn from history" - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Jinesh Joshi and Tanushree Banerjee.

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1 Responses to "This ratio is warning of a huge correction in stocks!"


Feb 19, 2015

I just use the simple PE ratio and dividend yield ratios of index to judge. Most of the time it gives a correct picture about the market.

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