From the Mythical Bubble into a Vacuum
From the Mythical Bubble into a Vacuum
Bu(r)sting the myth of the current stock market bubble
- Claiming that the equity market is in a bubble sounds sophisticated and conservative. However, is there any truth to it? And, if true, is it an actionable statement?
- There are more than 10 important questions that a Scientific Investor addresses to formulate an actionable investment management statement. These are discussed in this report.
- The primary liquid asset classes that an Indian investor can allocate to are Indian and US Equities and Indian and US Debt.
- US bond market is at an all-time high with a potential downside of approx. 45% in next 5-10 years. Indian bond market is also at a high relative to its long-term yields with a potential downside of 20%.
- The expected return and the risk evaluation across all primary asset classes clearly indicates that the primary allocation should still be made to the US and Indian Equities and Technology segment equity.
- Technology, being at the centre piece of the global economic ecosystem, commands an allocation in every portfolio. The current technology companies, with $100s of billions in revenue and $10s of billions in earnings and cashflows, should not be confused with the dotcom era companies with zero revenues and/or profits.
Surprisingly, the bubble
discussion is never applied
to the bond markets
There is a background buzz about the markets from wealth managers, fund managers, investors, economists, media and even the central bankers, in some cases, that the market is in a bubble. This bubble discussion, of course, applies to the equities markets, whether Indian equities or US equities or technology stocks or even others, but never to the bond markets.
The claims of a bubble are made combined with some or all the following statements:
- Market is in a bull run for 10+ years
- Market PE is high
- Market is at all time high
- Market is at $30+ Trillion
- Market is at 30% high for the year
- Markets are high despite the economy being in decline
This is supported by statements about a liquidity-driven rally; that the Fed and central banks are responsible for this; that the politicians and the bankers don't want the stock market to fall. Markets always meaning stock markets, never the bond markets are being propped up by central banks. No one accuses the Fed of trying to prop up the bond markets and gold markets.
Indian Investors should
allocate up to 20% to US
equity and 10% to the
Technology segment equity
In any case, the statement about the bubble in equities markets then begs the question about what next? Should one exit? Sure, what next? Where should the capital be allocated? It cannot exist in a vacuum. But hardly anyone discusses that.
The biggest thing which bothers the bubble-sayers is the bubble in the Big Tech. FAANGs are in a bubble! OMG! Each is valued at a Trillion! Never before has a company been valued at a $1 trillion. Oh no, $2 trillion! Again, one is not looking at the underlying fundamentals. How many companies before had revenues of $100s of billions and earnings and cash flows of $10s of billions? Many have more than $100 billion in cash sitting on their books.
What is the investment management question which a Scientific Investor would ask?
When someone says that the markets (any asset class) are in a bubble and investors should exit the following questions need to be addressed for it to be a comprehensive investment management statement.
- Are you expecting a downfall to happen? Why? What are the fundamental reasons behind it?
- Within what time frame do you expect the fall to happen?
- What is the extent of the fall according to you?
- Once you establish that the market is in bubble, what percentage of the allocation you exit?
- What will trigger the downfall?
- How much downfall you need before you start allocating back?
- How much further drop do you need for a full reallocation?
- During this period where do you park?
- What are the main asset classes where one can allocate capital?
- What about liquidity of each asset class?
- What about holding, transaction and other costs, and regulatory and tax burdens?
- Is each asset class compensating with sufficient expected returns for the risks it is exposed to?
What are the main liquid asset classes available to an Indian investor today?
While one could talk about equities and debt across multiple countries and regions, including developed markets, emerging markets, frontier markets, gold and other precious metals, commodities, real estate, infrastructure, private equity, venture capital, currencies, crypto currencies and so on, in our opinion realistically keeping liquidity, costs, regulatory barriers and safety, taxation issues, transparency etc. the practical asset classes which one needs to evaluate are limited.
Practically, for Indians today, the main asset classes that have liquidity and reasonably easy access are:
- Indian Equities
- Indian Debt
- US Equities
- US Debt
Expected Returns and Downside Risks for the main asset classes
The scientific investing question is: What are the expected returns from these asset classes? What are the risks?
We start with the US Debt, since the US treasuries are considered "risk free" and the yield available on them is considered the risk-free return available to anyone on which additional risk premiums are required for any other asset class. An understanding of the US debt markets will establish the base return numbers available to an investor today.
After the US Debt, we look at the US Equities and then Indian Debt and Indian Equities.
Let us start with the US debt. We focus on the US treasury markets. The following table lists the yields as of September 10, 2020. Further, the inverse of the yields which is the PE ratio is also shown.
While the concept of the yield of a bond is quite prevalent, the concept of the PE multiple of a bond is not commonly used. We introduce this concept here so that one can compare debt and equities with similar yardsticks of either yields or PE multiples. Someone coming across the concept of the PE multiple of a bond for the first time might find it bizarre. Keep in mind that the concept exists for quite some time and is published regularly as well by some research houses. For example one could track the bond PE ratios reports from Yardeni. (https://www.yardeni.com/pub/valuationfed.pdf)
This ratio helps one compare the bond markets with the equity markets. This ratio also highlights the extraordinary multiples that the bond markets are sporting.
The long-term average PE ratio for the 30-year US bond has been around 17-25. Currently, it is 70! It is about 3.5 times the normal multiple.
Returns from the US Bonds
The returns from this asset class are obvious if they are held to maturity. Currently, all the bonds except the 30-year bond yield less than 1%. The yield is what will be the return over the maturity period. However, if interest rates rise during the holding period and one is forced to sell the instrument, one is looking at a loss over the holding period. This risk increases for longer-maturity bonds. For shorter maturity bonds it is mostly going to be held-to-maturity.
If interest rates decrease further, which seems very unlikely but cannot be ruled out, one could make a potential capital gain.
Risks for the US Bonds
Assuming that it comes back to normal within the next 30 years, one is looking at a fall of nearly 75%. Over the next five to ten years, it is likely that the yields go back to the average over the last 5 years which is a yield of 2.6% or a PE multiple of 38. This is a fall of nearly 45% and it could be more if the inflation does reach up to 2% level. The Fed's dotplot also projects a yield centred around 2.5% in the next 5 years.
Now let us look at the equity yields and multiples for the US markets. We consider the following:
Expected returns from the US Equities
The expected returns from the US equities can be determined by combining the current yield with an estimated growth of the overall market. While the precise free cash flow yield is what is required, one can assume that nearly half of the Cash flow yield is FCF yield. Further, the real GDP over the next 10 years is expected to be around 2% and inflation is also expected to be around 2% (estimates based on the economic projections from the US Federal Reserve Bank on GDP growth projection of 1.6% to 2.2% and 2% inflation (Source: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20200610.pdf).
With these assumptions, for the S&P 500, the expected return comes around 6.5%. Similarly, one can determine the expected returns from other US equities classes. The illustration below lists down the expected returns from the broader market and the IT segment as per our estimation. With respect to the analysis on the expected returns, please see the section - Understanding Investment Risks at the end of the report and the detailed disclosures & disclaimers.
Risks for US Equities
The risks to US equities remain what they have always been. The S&P 500 had dropped by around 50% during the 2008-09 GFC. It reached the bottom in March 2009 and took around 4 more years to recover to its Nov 2007 peak. S&P 600 (small cap) had a broadly similar fall and recovery.
It is possible that similar risks exist going forward. Anyone investing in US equities should be prepared for a fall of ~50% in USD terms and a recovery time from the bottom to reach the earlier peak of around 4 years.
Looking at a more comprehensive data set for S&P 500 in INR terms of all rolling 1yr periods since Jan 1, 1979. The worst performance in INR terms is at -34.3% for a 1-year holding period. As one can notice, the worst fall in USD for S&P 500 was nearly 50% but in INR terms was only 34% signifying that during times of crisis the rupee depreciates significantly against the dollar. An asset allocation to US equities provides a strong cushion to an Indian investor precisely at the time it is needed.
Nasdaq 100 has fallen by nearly 80% during the dotcom bust and needed nearly 14 years to recover back to its March 2000 peak. However, other than that it has behaved similarly to S&P 500 with a 50% fall during the GFC. However, the recovery for Nasdaq 100 was much faster, less than 2 years from the bottom, as compared to S&P 500.
For Nasdaq 100 the worst performance in INR terms on a 1-year holding period basis was -68.5%. This worst performance was during the dotcom crash. During the dotcom boom there were many technology companies with zero profits and/or revenues. Currently, technology companies not only have some of the highest revenues across sectors ($100s of billions) but also some of the highest earnings and cashflows ($10s of billions). This makes the current and future technology segment, represented by Nasdaq 100, very distinct from the Nasdaq 100 during the dotcom era. Excluding the dotcom period, the worst performance in INR terms over a 1-year holding period for Nasdaq 100 was -33.8% seen during the GFC.
We have compiled the current yields for Government of India bonds of various maturities. We have also provided the PE ratios for these bonds.
We compare the current yields and PE multiples to the long-term averages. The long-term average yield for the 10 year is around 13-14. Currently, it is sporting a multiple of 17. This is around nearly 30% higher.
Returns from Indian Bonds
Assuming that the bonds are held to maturity, the returns from the bonds are the yield they are sporting currently. This can be assumed for the 3-month, 1-year and 2-year bonds; maybe even for 5-year bonds. If the interest rates go down further there could be a potential gain on these bonds. However, the likelihood is that inflation would go up during next 3-5 years and consequently interest rates could also go up, thus, creating a risk of capital loss.
Risks for the Indian Bonds
Primary risk that the 10-year bond is exposed to is the interest rate risk. It is likely that during the holding period the interest rates increase again and revert to the long-term mean which is around 7.7% yield or a multiple of 13. This indicates that there could be a capital loss of around 20%+.
Let us now evaluate the equity yields and multiples for the Indian markets. We consider the following:
Returns from Indian equities
We use a similar methodology applied to the US equities to arrive at the expected returns from various market segments.
The expected returns are around 11 to 13%. It is possible that the growth and inflation rates could be slightly higher, in which case, the returns could be in the 12% to 16% range. With respect to the analysis on the expected returns, please see the section - Understanding Investment Risks at the end of the report and the detailed disclosures & disclaimers.
Risks for Indian equities
The Sensex and Nifty dropped by around 55% during the GFC. It took nearly 5 years from the bottom to recover the earlier peak of Jan 2008. The mid and small cap indexes dropped nearly 75%-80% and took nearly 5-8 years to recover. A comprehensive analysis of Nifty 50 index performance of all rolling 1yr periods since Jan 1, 1999 reveals that the worst performance was seen during GFC and was -55.8% on a one-year holding period basis.
The Scientific Investing Deliberations
Given the current scenario in terms of the primary asset classes that an Indian investor has access to, what should be the allocation strategy?
It is understood that statements, such as, "Indian stocks are in a bubble so let us exit Indian stocks" are incomplete investment management statements. The statement is completed when one also mentions that the capital generated from exiting Indian stocks will be allocated to another asset class. It can be that one moves it temporarily to cash and then is waiting tactically for the Indian stock market to fall. In this case, the amount of fall at which the cash will be deployed back into Indian stocks has to be specified apriori. Further, there should be a concrete catalyst which would trigger that fall within a specified, reasonably short, time frame. There should be strong reasons to believe that such a fall will happen within the specified time frame and to the extent expected. Without the reasoning as discussed in the section "What is the investment management question which a Scientific Investor would ask?" there is no complete investment management statement.
Without such a well-reasoned and well-researched investment management statement, any other statements about market bubbles and exits can be classified under "timing the market" and have no practical use but are highly speculative and injurious to financial health.
Short of the above information, it becomes important to allocate capital to the right mix of asset classes.
We have rated the risk and returns for the 4 primary asset classes and 2 additional asset classes under equity namely, US IT and Indian IT. We summarize that below. Potential drawdowns for US equity, Indian Equity and US Tech are based on the maximum drawdowns observed on a rolling 1yr holding period basis for S&P 500, Nifty 50 and Nasdaq 100 respectively. Potential drawdown for US and Indian Bonds, Indian IT and US Tech (excluding Dotcom crash) are based on the OmniScience analysis and estimates.
The returns hierarchy seems to be Indian IT followed by US Tech. However, the US Tech drawdown risk going forward is much lower compared to Indian IT. In our opinion, the dotcom era drawdown is not relevant going forward since the current technology stocks have large revenues, profits and cashflows which was not the case during the dotcom. Considering the drawdown during the GFC, the US Tech is much less riskier compared to the Indian IT while sporting nearly similar expected returns.
This is followed by Indian Equities with slightly lower returns. US Equities have lower expected returns compared to Indian Equities but with much lower risks as well.
Indian bonds have much lower expected returns compared to US Equities but relatively lower downside risk as well. The Indian bonds have a clear edge over the US bonds in terms of both returns as well as risks. The US bonds comes last with low returns and high risks.
We can infer that contrary to the popular statements about bubbles in the Indian equities, US equities and US Technology stocks, the alternatives are sub-optimal. Further, the supposed alternatives of going to corporate bonds etc. would also not adequately compensate for the interest rate risks which would still exist but would be compounded further by credit risks which would increase substantially.
Real estate investments have become riskier post-covid due to the expected secular changes in Work-From-Home and Life-From-Home trends as discussed in our Digital Life report. (http://www.omnisciencecapital.com/entering-the-matrix/)
Private equity, venture capital, angel investing etc. are highly illiquid and unlikely to be providing high returns due to overcrowding in these markets. Historically, these asset classes have proven to be capital destroying for most investors except for a small minority.
OmniScience Capital offerings in US and Indian Equities
The following 3 exhibits summarise the comparison of OmniScience Offerings with the respective benchmarks on price multiples, implied earning/ cash flow yields and finally on return on equity:
Now comparing all six key liquid asset classes (US & Indian Debt, US & Indian Equity, and US & Indian Tech) one can infer that it is important to allocate capital to all 4 equity asset classes. Given attractive valuation and superior fundamentals for India Supreme and US Supreme compared to the respective benchmarks one may infer that these have the potential to deliver better performance over long term. Similarly, the technology strategies, Omni AIoT and Omni DX may also offer better performance over long term compared to their respective benchmarks. It may be noted that for Omni DX the strategy benchmark continues to be Nifty 500 in the absence of a true representative technology index.
Understanding Investment Risks
We would like to highlight the risk factors and make due disclosures with respect to the above discussion on the expected market returns and proposed equity allocations:
- With a potential for profit there is also a possibility of loss. Therefore, investors may lose capital in markets.
- Past equity market or strategy performance is not necessarily indicative of future results. There can be no express or implied assurance about strategies' absolute performance or relative performance.
- Equity investments are subject to market risks. Markets can go down by 10%-20%-30%-50% or even 70%+. Markets can remain down for 1-2-3 years or more. Long term outlook and commitment of 5 years or more is necessary to increase the likelihood of meeting one's investment goals.
- Individual stocks in the portfolios can lose up to 100% of capital
- No investor can consistently enter the market just before a rise and exit the market just before a fall
- Expected returns can be estimated based on various methodologies. However, all estimates will necessarily have a low confidence level given that the future is likely to be very different from the past.
- While we attempt to outperform the respective benchmark over the long term, typically 5 years, there can be no assurance or guarantee that this will be achieved.
Equity Asset Allocation for an Indian Investor
The core strategies, i.e. India and US supreme should be given around 70% allocation with another 30% allocation to the technology strategies. For an Indian investor who does not have any immediate needs from this capital for the next 5+ years, the following is a possible allocation to be made over a three year period:
Equity Asset Allocation for a Global Indian Investor
A global Indian investor is someone with their primary assets in non-rupee i.e., USD or other global currencies. Typically such as investor would also be holding foreign citizenship of residency and have significant long term USD obligations in terms of healthcare, travel, children education, etc.
Investors can allocate to the following investment offerings from OmniScience to take the respective investment exposure.
To get a feel for how global equities have performed in the long term for an Indian investor who has just started to explore investing in the global markets you can refer to our report comparing the global and Indian market returns, in INR terms, since GFC. http://www.omnisciencecapital.com/global-indian-market-returns-since-global-financial-crisis-gfc-2007-2017/
To understand the Scientific Investing philosophy, you can refer to our report A Fable of Four Folios. http://www.omnisciencecapital.com/a-fable-of-four-folios/
To know more about the Multi-trillion dollar Digital Transformation (DX) and Artificial Intelligence & Internet of Things (AIoT) investment opportunity and to understand why you need to allocate separately to these equity classes which are becoming centre piece of the evolving global economic ecosystem refer to the following reports under the research section of our website http://www.omnisciencecapital.com/category/research/
- Omni DX launch report - http://www.omnisciencecapital.com/digital-transformation-dx-gateway-to-a-100-trillionopportunity/
- Omni AIoT US Launch report - http://www.omnisciencecapital.com/aiot-artificial-intelligence-the-internet-of-things/
- "Enter the Matrix" report on AIoT - http://www.omnisciencecapital.com/entering-the-matrix/
We would like to remind the reader of Peter Lynch's famous adage:
Far more money has been lost by investors trying to anticipate corrections, than lost in the corrections themselves.
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Disclosures & Disclaimers
Omniscience Capital Advisors Private Limited (Omniscience Investment Advisers) is a SEBI registered Investment Advisory firm with registration no. INA000007623.
Equity investments are subject to market risks. Global investments are subject to currency risk, country risk and other risk factors. Please read all related documents carefully. An investor should consider the investment objectives, risks, and charges & expenses carefully before taking any investment decision. Wherever there is the potential for profit there is also the possibility of loss. Therefore, investors may lose capital in markets. Past performance is not necessarily indicative of future results. This is not an offer document. This material is intended for educational purposes only and is not an offer to sell any services or products or a solicitation to buy any securities mentioned or otherwise. Any representation to the contrary is not permitted. This document does not constitute an offer of services in jurisdictions where the company does not have the necessary licenses.
Performance is based on the investments done in portfolios with proprietary money. The performance numbers are pre-expense and unaudited. Global portfolios are maintained by an independent global custodian and the performance is calculated based on the portfolio holdings. India portfolios are maintained by Orbis Financial Corporation ltd, an independent, SEBI registered custodian and fund accountant; performance is based on the NAV maintained by the fund accountant. All benchmark returns and global portfolio returns are price returns starting from May 1, 2020. Beta and Standard deviation are calculated based on daily returns since inception. Individual returns of Clients for a particular portfolio may vary significantly from the mentioned model portfolio performances and the performance of the other portfolios. No claims may be made or entertained for any variances between the performance depictions and individual portfolio performance. The data is provided as an illustration of the behavior of the strategy under different market conditions. Reader should not use it to form an opinion about the future returns from the strategy. No express or implied guarantees or warranties about the accuracy and/or completeness of the performance are being made and OmniScience Capital shall have no liability for any damages, claims, losses or expenses. Neither the investment adviser nor its Directors or Employees shall be in any way liable for any variations noticed in the returns of individual portfolios.
Our discussion may include assumptions, estimates or other information that might be considered forward-looking. While these forward-looking statements represent our current judgment on what the future holds, they are subject to risks and uncertainties that could cause actual outcomes to differ materially. We assume no obligation to revise or publicly release any revision to these forward-looking statements in light of new information or future events. No guarantee can be given about the accuracy and/or completeness of the data, Omniscience makes no warranties or representations, express or implied, on the products and services offered. It accepts no liability for any damages or losses, however caused, in connection with the use of, or on the reliance of its product or services. The information relating to any company or economic trends herein is derived from publicly available sources and no representation as to the accuracy or completeness of such information can be made. We may have recommended stocks, or stocks in the mentioned sectors to clients, including having personal exposure.
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