As investors celebrate the new highs hit by the markets, the current trend hides a dangerous secret. Close to eight out of every ten industries now trade higher than their own historic premiums. In this cover story, we look at the precarious situation brewing and what it means for investors.
The Sensex hit its lifetime highs of 30,000 in early April this year. This was accompanied by a general sense that the markets have only one way to go - up. In an example of how the optimism has taken root in the minds of investors, consider this: a chartered accountant this writer visited at the close of the previous financial year, commented coolly, "market toh abhi upar hi jaega." When asked why, his response, a blank smile.
The more optimistic active market participants, though, are not as clueless as the average investor as to why the markets will go up. Normalisation, and even higher economic growth, post the demonetisation hiccup, the rollout of GST, and a stable government at the Centre going well into 2019 are among the chief factors behind the enthusiasm. What has also helped keep the optimism going is an improvement in the global economy that is coming out of a deflationary position. When global markets rally, Indian stocks go up, too.
This general sense of optimism has turned valuations up. The markets, in general, and many investors, in particular, are now more comfortable paying a higher premium for stocks, especially considering past premiums. Before the dot-com bubble collapsed in the year 2000, the Sensex P/E was close to 30x. Before the global financial meltdown of 2008, the P/E was close to 27x. Those were market peaks. Today it trades at 23x.
What could turn a party pooper? There are two kinds of risk in the market: the known and the unknown. Among the known, corporate earnings growth and the state of the monsoons could impact the optimism in the markets. What's more disconcerting is the unknown risks that the market usually never discounts. Will the crisis in Syria spiral out of control? The war-torn country may be far away from India, but any escalation, especially between the US and Russia, could pose serious threats to global stability and growth.
An overwhelming majority of major industries (see the table below) is now more expensive than their own historic trading averages. Following is the advice of many reputable fund managers, including that of Howard Marks, the co-founder of Oaktree Capital Management, which manages $101 billion in assets: it is time to turn cautious when markets see only one way to go - up. Also keep in mind, just because the markets are becoming expensive, it doesn't mean a fall may come any time soon. The markets can remain expensive for more time ahead.
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