The Pendulum of Share Prices

The Bottom?

“Will Indian equities fall further?”

A friend and collaborator asked me yesterday.

There can be no definitive answer to this.

Even if you believe - as I do - that the broad market is over-valued. And has been for a long time. Stocks, like all assets, can hold inflated prices for a long time. This has been true of global assets ever since the flood of money in response to the pandemic. In India, equity prices were buoyed by surging interest in Systematic Investment Plans (SIPs), successfully marketed by mutual funds, aided by poor returns to fixed deposits in banks.

Over the last six months, the sheen has come off Indian equities, but by my markers, they continue to be over-priced. My markers include the ratio of stock market capitalisation to GDP, and the average growth (CAGR) in major indices when compared to the growth in the economy.

Over the last five years, the formal economy has been growing at about 6 per cent per annum. The informal economy, on the other hand, has been stagnating, and this is now feeding back into overall growth. But, even if we hold the 6% growth number, and add 6% for inflation, India has been growing at 12% per annum in nominal, or rupee terms. But till recently, the Nifty was showing a growth rate of 15%. This divergence cannot be sustained.

But: does this mean that the markets were bound to drop? I didn’t think so. If I did, I would have sold everything I owned, which I didn’t. Thing is, markets can correct in two ways. The first is the obvious one, by a drop in prices - ‘price-wise’.

The other is particularly relevant in a growing economy. Consider the marker of market capitalisation to GDP. Since GDP is continually rising, the ‘rational’ value of market cap is also growing. Currently, the market value of all Indian stocks is 1.4 times GDP. Say I believe this ratio should be 1.2 or less. An overnight drop of 14% in stock prices would get us to my optimal level in one stroke. The other way could be ‘time-wise’, where GDP keeps growing, but market cap doesn’t; in a little over a year, the market cap to GDP ratio would look more reasonable.

The distinction between price-wise and time-wise corrections is very useful, but reality deploys both. Together, or first one and then the other. And rarely in a linear fashion. Price corrections, particularly, can be savage, and an over-priced market can over-correct, so you suddenly have a market that is under-priced. Pendulums take a long time to settle in a vertical position - when they are let loose from a height, they can swing pretty violently in the opposite direction. And, learning from physics, the speed of the pendulum accelerates as it hits the bottom of its swing.

All this is by way of saying, “I don’t know for sure”.

We need to view markets in a probabilistic way, not a definitive one. So, yes there is, and has been, a high probability that markets will correct, time- or price-wise. Trump’s wild cards don’t help, and I think we are more biased towards a price-wise correction. This is something I hugely prefer, because it clears the air, the pendulum settles rapidly, and stock-pickers can get in and start buying all over again.