Are the Stock Markets Deaf to Covid Agony?

• "I don't know if I am the only one, but stock markets going up the last 3 days not caring about everything happening around us is quite disgusting.
  
  I know money shouldn't care, but maybe it should. Maybe why today's capitalism is broken?"

This was the tweet from Nithin Kamath, CEO of India's largest discount broker Zerodha few days ago.

I am sure many of you would relate to what he has to say.

On one side, the Covid situation is extremely grim. About 30-40% of the country is in a strict lockdown, with many more states likely to impose curbs.

On the other hand, the stock market which is considered the economic barometer of the country seem oblivious to the ground reality.

The Nifty was up 2% for the week ending 30 April 2021 while India added the highest number of cases and deaths for the week.

Why such a dichotomy?

The most common answer to this paradox is this. The stock market is 'forward looking' or the bad news is already discounted in the price.

However, the million dollar question is this. How much is really priced in or how far ahead does the market look?

Let me try to dissect the divergence between the economy and the stock markets.

Observation 1: During tough times, the big get bigger while the small wither away

The constituents in the stock market represent the formal/organised sector.

The large cap stocks are the market leaders while the mid cap and the larger small cap companies are part of top 5 in terms of market share.

In case of a slowdown, it's the smaller unorganised sector without the means to financing or at least low cost financing that get killed.

In fact, you shouldn't be surprised that the leaders thrive in a downturn at the expense of the unorganised sector.

Headlines of highest ever GST collection of Rs 1.41 trillion in the month of April (for the March 2021) period indicates the formal sector is bouncing back at the expense of the unorganised sector.

Over the past 1 month, you must have observed a divergence between the Bank Nifty and the Nifty.

The anticipated stress in the informal and SME sector is reflected in financial stocks. As retail lending constitutes substantial portion of the lending book, the underperformance is rightly evident.

Observation 2: Never fight the Fed

As a kid my parents use to tell me there are no free lunches. Money doesn't grow on trees. Today I tell them money doesn't grow on trees but in central banks.

You must have come across this phrase multiple times in the recent past - Never fight the Fed.

Markets are going up due to liquidity pumping by central banks all over the world

Let me tell you what it means.

It's estimated the US Federal Reserve has printed 22% of all the US dollars in history in just 1 year (2020).

The size of the US stimulus package was U$$ 2 trillion - That's the size of India's GDP.

Now that is astronomical.

The near-term impact is big boost to asset classes globally. In simple words, if there is printing of money going on, it will flow to some assets.

To be specific, the money is flowing to high yielding assets, inflating the price of the particular asset.

That's what is happening to equities and commodities all over the world.

Also, printing US dollars will have a negative impact on it, making emerging markets and commodities all around the globe more attractive.

The dollar index (DXY) has declined by 10% over the past 1 year on account of massive dollar printing by the federal reserve

A weak dollar brings flows to emerging markets like India. That's the ripple effect of liquidity.

Observation 3: Welcome to the world of near zero interest rates

Let's relate this to one of the most important things that affect asset returns - Interest rates.

In the Indian context, interest rates are trending downwards thanks to folks at RBI. Traditional assets like fixed deposits become unattractive.

Imagine getting a return of 6% pretax as against inflation of 5%. Also inflation for urban India and the middle class is higher than the official CPI inflation of 5%.

FDs barely give you 1-2% real return. Real estate is unattractive in a downturn because the ticket size is huge. Bond yields are at very low levels.

Where does money flow?

Equities.

In the global context, negative bond yields in many developed economies has led to money moving out from bonds to equities.

Observation 4: Valuations and interest rates have a strong correlation

A decline in interest rates brings down the most important factor in valuing a company and consequently the stock market i.e. the discount rate.

A 1-2% reduction in interest rate can lead to about 8-10% earnings boost when long term earnings are discounted at a lower rate.

This makes the PE ratio going forward much lower and valuations look reasonable.

To sum it up, we are in a world of massive liquidity facilitated by currency printing all over the world.

With money chasing growth assets, equities will continue to be the preferred bet.

The party will last till inflation does not inch up beyond a tolerable threshold.

Till then it's time to enjoy the party.

At the same time, keep looking at the door. You should exit when the music starts to fade.

Warm regards,


Aditya Vora
Financial Writer