In my previous column, I had discussed growth and valuation as two components of my four factor model for determining market direction over the medium term. In this column, I discuss the other two macro components – liquidity and interest rates, and how to tie up all the factors to estimate market direction.
Liquidity can be interpreted in various ways. In simple terms it determines the extent of mismatch between demand and supply of money. Since monetary authorities often attempt to “manage” liquidity through market operations, a market driven measure is difficult to find. We often have to do with proxies.
At a macro level, liquidity can be measured through money supply (called M3 by economists). As the graphs demonstrate, M3 as a forecaster of market direction worked well for most of the decade of 2000. Post 2008, the correlation between market direction and M3 apparently broke down – central bank interference has, since, become the norm.
Other measures of liquidity can be FII flows, the liquidity adjustment facility of the RBI or measures such as TED spread (price difference between three month futures on US treasuries, and the identical contract in Euro).
At the level of the market, liquidity is easier to measure. Volatility can be taken as a proxy – lower the volatility, higher the liquidity. Other measures include impact cost of trades (difference between the buying and selling price) or intra-day high-low of stock prices.
Whatever the measure, the impact is likely to be the same. Easing of liquidity conditions helps in taking the market up. The reverse is true when money becomes tight.
An interesting outcome of this is the impact on “mid-cap” or less-traded companies. Smaller companies usually trade at a valuation discount to the larger, well-traded companies. This often leads “value investors” to invest in these companies. While this may be a valid strategy for someone having an investment horizon exceeding 5 years, it can be painful for investors (or fund managers) who look for near term performance. When liquidity dries up, the smaller companies are the first to feel the impact of tight liquidity and fall in stock prices of such companies is usually steeper than their larger (more liquid) counterparts. In other words, invest in mid-cap value only when liquidity conditions are benign, and are likely to remain so. Value investing can easily become a value trap for the unwary.
Interest rates are fundamental to valuing any asset – financial or real. At the heart of investing is the desire to earn a return that preserves or grows the value of money. Interest is the benchmark for measuring the effectiveness of any investment. Since the concept of interest is relatively simple, I will not attempt to explain it. However, I have often observed that most people do not realize that value of all investments fall when interest rates rise – equity, debt or real estate. A simple way to understand this is to see all assets as generators of cash flow – dividend, coupon rates or rent. We use present value of these cash-flows to measure the value of each investment and that uses interest in the denominator. In other words, unless the cash flow from investment increases when interest rates rise (for example, in the case of inflation adjusted bonds), asset prices will fall when rates rise.
Another point worth mentioning is that liquidity and interest rates do not need to move in the same direction, though they may. It is therefore necessary to examine each separately.
In the market, all interest rates are not equal. I had earlier referred to a study by the RBI where it postulated that inflation rate below 6 per cent may help growth while above it, it is likely to harm. Likewise, when interest rates rise above 7-8 per cent (from lower rates) impact on markets is more adverse. Increase in rate from say 4 to 5 per cent is less likely to impact. This is explained by the assumption that at lower levels, the differential interest rates can be passed on to consumers – without impacting corporate margins and therefore protecting (enhancing in nominal terms) the cash flow. However, higher rates meet consumer resistance forcing companies to absorb the rate increases with consequent lower margins. Likewise, on the way down, a drop from 8 to 7 per cent is more likely to have a positive impact than one from 10 to 9 per cent.
The last question to consider is what interest rate we are referring to. For the purpose of the stock market, we should look at the borrowing cost of companies. Since this varies from bank to bank and company to company, it is normal to consider the base rate of banks. Even simpler is to track the repo rate: the rate at which banks borrow from the reserve bank.
Putting it together
In the very short term, liquidity overwhelmingly determines the direction of the market – higher liquidity leads to higher market levels and vice versa. However, over the medium term, say 3 to 6 months, the dominant factor is the earnings and its growth. Higher growth will support higher levels. In a benign interest rate scenario, or one where interest rates are expected to fall, valuations will rise.
In all this, change in levels is more important than the level of each variable. However, when variables cross thresholds (for example, interest rates go beyond 8 per cent, or earnings rate falls below 15 per cent) the impact is greater.
In the current context, as we mentioned earlier, earnings growth is expected at 12 per cent (anaemic but better than last year: positive), interest rates may fall further (they are at the threshold of 8 per cent: a further cut can have a large upward impact on markets: positive). Liquidity is poor (M3 is falling: short term negative), but valuations (at around 13-14x: positive) are at the lower end of the 12x to 18x band. Downside in the market can therefore come from liquidity shocks. Otherwise, potential upside to downside risk is in favour of the equity investor. Buying dips may work well for the patient investor.