In an article dated May 31st, 2017, I wrote that the Indian stock market had room to run on the upside and that a 20% increase over the next two years was highly probable. I mentioned two things that would bring an end to this bull run: a declining currency, and disappearing liquidity.

Since that writing the market has gone up around 19.5 %, the rupee has dropped to reach an all-time low of 69 (USD/INR), and liquidity is disappearing from the market.

It is time for investors to consolidate their gains, and find the safety of cash.

In a free market (one which is not manipulated or controlled) the price of anything ( including stocks) is determined by supply and demand. If more people want to buy a stock at a particular price than to sell at that price, the asking price of the stock will go up. And vice versa, if more people want to sell a stock than want to buy it, prices will come down. In the good old days there were gifted “ tape-watchers” who could study the bid and ask data to identify these subtle market demand and supply movements, but with electronic market making and high-frequency algorithmic trading that art has disappeared.

But other clues can point to shifts in demand and supply.

One of these is the market depth. In a good market with supportive macroeconomic factors, there is a wide range of good companies that are growing and making profits. In such an environment a large number of stocks have price increases, and the dispersion of returns across the range of stocks on the exchange is low. But when only a few stocks are doing well, it is an indicator of deteriorating market depth and a harbinger of bad times for the market.

Depth is fast disappearing from the Indian stock market. Only a handful of stocks are keeping the broad market up. The large-cap dominated S&P BSE Sensex Index is up around 7% for the year, but the S&P BSE Mid-Cap index is down 18%, and the S&P BSE Small-Cap index is down about 24%. Nine out of every ten stocks in the S&P BSE 500 broad market index have fallen in price this year. The average monthly advance-decline ratio which measures the proportion of advancing stocks to declining stocks is at its lowest level in the last 20 years. This is a sign of a market losing depth and demand drying up and is a warning sign for the stock market.

Foreign investors have been big buyers of Indian stocks in the past. This buying has brought liquidity into the market and helped push prices up. But there is growing evidence that the declining rupee is making foreign investors nervous about the high valuations of the Indian market. A falling rupee lowers the realised return for foreign investors–a 5% drop in the rupee is tantamount to a 5% drop in the value of their portfolio. Over the last three months, foreign investors have pulled out Rs.13,300 crores from the Indian stock market. This will create liquidity problems and put downward pressure on prices.

How about valuations? Are Indian stocks reasonably priced? Investors evaluate the price of an investment relative to either its expected earnings or its book (accounting) value. A commonly used metric is the price-to-earnings (PE) multiple. The standard approach is to forecast a company’s earnings based on projections of its sales and general economic conditions. This approach can be problematic for developing economies like India where there is significant variability in corporate earnings. Additionally, it is more difficult to forecast earnings accurately in an economy where there is greater government control over capital and product prices than it is in a free market economy.

A better indicator is the cyclically-adjusted-price-earnings (CAPE) ratio developed by Nobel prize winner Robert Shiller and John Campbell. It smooths out the variability in corporate earning by taking the inflation-adjusted earnings of the previous ten years. The CAPE multiple measures the price of an equity market relative to an average earnings level to which it will very probably return.

The following table shows the expected 10-year returns from investing in different CAPE regimes. The best time to invest is when the CAPE is less than 10. Expected returns drop linearly as CAPE increases.

Data from Siblis Research ( estimates that the March 2018 CAPE ratio for the broad Indian market (Nifty 500) to be 24.62. This suggests that the best an investor can expect from the Indian stock market over the next ten years is a return of around 5.7%.

Another widely used valuation measure is the Price-to-Book (PB) multiple. In some markets, the PB multiple may be a better indicator of valuation because book values are less volatile than earnings and don’t require smoothing. The following table provides the average long-term returns from investing in different PB regimes. As with CAPE, investing in markets when PB is low provides higher returns.

The PB multiple for the S&P BSE Sensex index is currently 3.03. This indicates a highly overvalued Indian market with low expected returns over the next ten years.

The Indian stock market has had a good run. But is currently overvalued with poor depth and declining liquidity. Add to that the uncertainty of upcoming elections. This would be an excellent time to clear the deck and find the safety of cash.

What if I am wrong? There is a finite probability that I could be wrong and the market may keep going up. I can’t see the future any more than the next person. But as a hedge fund manager, I am trained to think probabilities and opportunities. And I see only a small probability of the market returning more than 7% ( the opportunity cost of capital) over the next year. I would rather cash my chips and park my money in a short-term fixed deposit and have liquidity ready for the next big opportunity.  Periods of uncertainty, like we currently face in India with a growing banking crisis, will throw up unexpected opportunities. In this environment cash is your best friend.

The author would like to thank Siblis Research ( for data. 


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2019-03-20T13:25:45+00:00 July 22nd, 2018|

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