Overvalued is one word that is on top of the minds of investors given record high levels of equity markets across the globe including India. We (Me & My Team) are constantly asked whether equity markets are overvalued and should one enter, exit or stay away from equity markets. The question keeps cropping up despite our comprehensive view on equities, we have put out a Presentation on Sensex at 40k in 2019.
The 1st question to ask before replying to the question on overvaluation is “What is Overvaluation”. The most common answer to this question is that markets are ahead of fundamentals and are over optimistic on growth. The overoptimism is measured by the PE Ratio (Price Earnings Ratio) which is the ratio of EPS or Earnings Per Share to the price of the stock. Click here for tutorials on Equity Ratios.
PE’s have risen in this rally in equity markets and that is causing concern amongst investors. Is PE the right judge of valuations? Listen to my podcast on “Is PE the right judge of valuations” where i say that if you looked at PE you would have missed out all the gains from the worlds largest wealth creators such as Amazon, Apple, Facebook and unicorns such as Uber and Airbnb. PE may not be the only factor for overvaluation.
What are the other causes of overvaluations? Excessive debt is one significant cause of overvaluation where promoters borrow and invest for growth and investors borrow and invest for returns. The 2008 financial market crisis was due to excessive leverage. In the current scenario, leverage is low in the markets. Credit growth in India is at below 10% whereas prior to 2008 it was at 30%. Globally too banks are reluctant lenders on the back of the after effects of 2008.
Liquidity is one cause of overvaluation and with central banks from the Fed to ECB pumping in trillions of dollars of liquidity, equities have benefitted. Now with Fed turning off the tap and ECB and others likely to follow next year, will markets react? The Fed had turned off the taps in December 2014 and markets have gained in strength, which shows that there are other aspects at work that are taking up markets.
Corporate health is extremely high as post 2008 financial crisis, many corporates went through lot of pain to restructure businesses. Balance sheets were deleveraged, businesses were restructured and excesses were brought down and many corporates are lean and mean now. Globally tech giants cash pile has grown substantially indicating the quality of earnings.
Corporate health being good and signs of economic growth coming through with better data coming out of US and Eurozone, quality of earnings is rising. This is being appreciated by the markets and will continue to be appreciated until corporates over extend themselves again.
Markets are not really overvalued, its only the levels that are daunting.
Listen to my podcast below on why levels will daunt but markets will move where they want to.
Transcript of Podcast:
Hi I am Arjun Parthasarathy speaking and this podcast is on “Of Earth’s History & Equity Record Highs”
Watching documentaries on the formation of continents, you realise that time is immaterial. 500 million years may seem too long but in the context of the whole universe, even that gets dwarfed. As humans we live for 70 years to 100 years and in the context of time, it is too insignificant. Hence we try to make the best of what we can in such a short span of time.
I am talking about time in the context of equity markets. Globally, equity indices in the US are trading at record highs while many indices in Europe are trading at record highs or close to record highs. In India, small and mid cap indices touched record highs this week while large cap indices are trading to close to record highs.
Record high levels in equity indices are giving rise to fears of overvaluation, markets running ahead of fundamentals and higher volatility. However, looking back the market has touched many record highs to reach current record high levels. At every record high level, same fears are raised. If investors had given in to the fears, they would not have reaped the benefits of markets touching record highs.
Going forward too, the current record high level would be past history and markets will touch more record high levels. This may happen over the next few years or may happen over a much longer period of time, which may or may not suit you. Or markets may still be searching for record highs. For example, Japan’s Nikkei touched record highs in the late 1980’s and have not seen highs for over 25 years. Nasdaq took 16 years to touch record highs after it peaked in 2000.
As an investor, what you need to focus on is whether markets at record highs are factoring in euphoria, which is almost always misplaced, or not. Euphoric markets are heady and investors are told to believe that nothing can go wrong. The last euphoria was seen in 2008 and markets took 6 years to recover from the euphoria.
In the context of time, markets do not recognize your age, risk preference, country of residence and other demographics. The earth too does not recognize the current civilization, it does what it has to do and maybe over the next few hundred millions of years, new continents may form. Markets too may grow to levels unimaginable now or may not grow at all for ages.
As an investor, you need to focus on your current savings and whether it is enough to sustain you for extended periods of time when your regular flow of income stops. Growing your savings and avoiding the pitfalls that come with it are important. Hence what you need to check for is whether markets at record highs at present will continue to grow in the next few years or will fall from record highs and stay down. Invest in equities with this checkpoint and not on the basis of your own demography.
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