The volatility seen in equity markets over the last one month that has brought down the Sensex and Nifty to over one year lows looks to be coming to an end.
Why do I say this and should you look to be buying now at lower prices of stocks?
Answering each question in turn. Why do I say that the current market volatility is coming to an end?
Volatility increases as a result of uncertainty associated with the expected return from an asset like stocks. Stock prices are largely affected by three factors a) Sentiments b) Business & Economic environment and c) Liquidity.
There are mainly two Sentimental reasons why global equity markets are witnessing volatility at present. As repeatedly stated by many reports and articles the main reason for this is that China, which is the second largest economy in the World is headed for a further slowdown in growth and the other one is the decision of the Fed to raise interest rates in the US economy, which have been kept at near zero levels for a long time since 2008.
I am saying sentimental because China slowdown had already happened with GDP growth coming off from levels of over 10% to 7.5% levels. Growth slowdown from hereon will not be as dramatic and China will have to live with moderate growth given its huge economy. Market volatility happened when China’s equity markets rose and fell dramatically over the last one year, which is more of a reflection of the underdeveloped nature of the markets rather than any growth issues.
The Government in China in trying to curb volatility by introducing a slew of measures from banning investors to trade in the stock market to introducing circuit breakers to stop unnecessary speculative activities had worsened the volatility. Banning investors from trading or selling stocks to prevent fall in the asset prices or introducing circuits is not going to change the fundamentals of the stocks in China. Expensive stocks have to normalize to realistic levels even though the benchmark indices have corrected 40% from the peak levels of June 2015. In fact stock prices have to be in sync with the expected growth in the earnings of companies in a bleak macroeconomic environment where exports are falling, interest rates are being reduced and property prices are inflated. If the Government in China keeps on implementing or introducing measures that are too superficial for the markets to reflect the correct state of the economy volatility is here to stay.
The Chinese government has realized the futility of intervention and will take steps towards a hard grind to improve market sentiments.
The second sentiment, Fed rate hikes is completely overdone. The theory that money will flow out of emerging markets to higher yielding US treasuries is not valid as the US ten year treasury yield is 80bps down from highs seen in 2013.
The US markets are fine with the Fed hiking rates and are pricing long periods of low inflation leading to the fall in US treasury yields.
The China sentiment and Fed rate hike sentiment will improve as China’s markets stabilize and the Fed actually hikes rates. It is the same case as when the Fed spoke about withdrawing QE in 2013, markets tanked but when it actually stopped QE, markets rallied to all time highs.
Business & Economic Environment
The business and economic environment is looking both positive and negative depending on the drivers of businesses and economies. Given the commodity market weakness, all businesses and economies dependent on commodities are suffering.
Equity markets have already priced in that suffering into the stock prices. US, European markets have outperformed markets like Russia and Brazil that are commodity dependent economies.
US and Germany are doing well as economies while India too is being seen as a stable economy given the domestic consumption driven economy. Business that benefit from lower commodity prices and low inflation expectations will do well and that will reflect changes in leaders driving equity indices.
Liquidity drives asset prices and if cost of liquidity is cheap then liquidity will search for returns. Liquidity is extremely cheap in the world right now. Borrowing is USD costs less that 0.5% while borrowing in Euros and Japanese Yen costs less than 0.25%. Central banks are flooding the market with liquidity given prospects of low inflation to deflation led by low commodity prices.
Liquidty when it finds that asset prices are looking attractive after a correction will embrace those assets for returns and given that equity markets are not seen as being in a long term correction like as in commodities, money will flow back into equities.
Should you be looking to buy at lower prices of stocks?
The decision to buy stocks should be based on your exposure to stocks as a percentage of your total assets and whether you are comfortable increasing the exposure. If you believe you are already fully invested then you would have to think twice about bottom fishing and if you believe you have more room to invest then you can buy into the market.