Shankar Sharma’s take on smallcaps: Could the bull be getting tired?

You never count your money

When you're sittin' at the table

There'll be time enough for countin'

When the dealin's done":

The Gambler,Kenny Rogers

We are all hurting , aren't we?

Indeed we are. In fact , we are angry. What looked a sure thing in February, has become less so in March. Why is this paradise getting lost right in front of our dewy eyes?

But was it a sure thing at all in February?

That's where some thinking helps.( Thinking doesn't always help though. Look at the past 4 years!).

I do also understand that analytical thinking almost always is  problematic.

Lazy, under-analysed, over-simplified opinions are comforting.

Like chamomile tea.

Analysis is four espresso shots.

In the Indian model of investing that I have seen for the last 30 plus years, data are only supposed to be looked at one way and any other conflicting data are supposed to be conveniently swept under the carpet.

But the millions of young investors who have entered the markets in the last four years should not grow up believing that data do not matter.

Data do matter and they matter most in the stock market.

That's because the stock market is never a sure thing. The stock market is nothing but a game of chance which is,  at some level, broadly equal to placing bets at a casino.

Both sets of "gambles" have probabilistic outcomes.

At the casino, however, there is a big difference: your bets are supposed to get squared up by end of playtime.

In the stock market, it is not so in so far as the investing part of the stock market is concerned (not so in the derivatives part, of course).

However, the fact remains that even the investing part of the stock market is a game of several probabilities in which the most probable may not actually come through and the least probable might transpire.

But a good question that should be at the forefront of every investor at every point in time should be: what do the probabilities say at that point in time?

And that is exactly where some basic back of the envelope data analysis helps.

So here I resort to my self-created, Nobel prize-worthy ( sorry for the shameless plug) Lake of Returns Theory ( LORT).

What LORT posits is every asset class has a certain finite amount of returns that it can hold and deliver. That is the Lake of that asset class'  Returns.

For example, the Sensex Lake of Returns tells us that it can deliver us around 15-16% CAGR over an extended period of time. That's pretty much the amount of water (returns) the Sensex Lake can hold.

Therefore,  what exactly is the Lake of Returns Theory. If any particular asset class has more or less a predictable return characteristic (most do, except Cryptocurrencies because they are too new), which is the amount of water or returns it can hold in its reservoir or lake, then we can reasonably predict future market movements based on the level of water or returns in that particular asset class in the preceding period.

In a bear market, the level of water in the lake of returns falls to abysmal levels.

Think of the extremely dry lake in the period mid-2000 until  early 2004. The Sensex had done precisely nothing except go down. So the volume of water in the Lake was next to 0.

And then a massive wave of water filling started from 2004 onwards which lasted right until 2007 end.

In that period, the Sensex compounded ~50% CAGR!

And that is when sitting in my trading room, watching the screen go wild in the months of September- October 2007, that the Lake of Returns Theory hit me: like a laser beam in a dark theater.  It became so blindingly obvious to me that that bull market (04-07) was pretty much near over. And that is because while this asset class (Sensex) is supposed to deliver 15% annual return, it had given us 50%+ annual returns for the preceding 3-4 years.

So now the Lake of Returns was overflowing and was close to flooding over and destroying all the villages bordering the lake. This Lake simply did not have the capacity to hold so much water and deliver it in a orderly fashion to the people living on the banks. The banks and dams had to burst and calamity had to follow and by January of 2008, the magnificent destruction was there for all to see.

So what does the Lake of Returns Theory now tell us?

Chew on this:

SENSEX:

A. The SENSEX has returned from May 2014 up until now ( ~10 years), a CAGR of ~12%.

B. Importantly, from May 2014 to (pre- Covid) February 2020, Sensex returned just 9% CAGR .

C. From Covid lows to present day, Sensex has returned 27% CAGR.

D. From February 2020 ( pre-Covid peak ( 41k level) to present 73k), it's delivered CAGR of just ~15%.

Analysis: much of the 10 year- 12% CAGR for the Sensex has come from just the post COVID rally. The returns or the level of the water in the Lake, prior to the pandemic,  was extremely low (9% CAGR, well below long term trend) .

And that is exactly why the water level filled rapidly post pandemic, delivering 27% CAGR in the past 4 years.

BSE Small Cap Index:

E. Past 10 year returns: 18.5% CAGR

F. May 2014- February 2020: ~9.5% CAGR

G. Post COVID lows to present day: 47% CAGR

H. February 2020 to present day: 32% CAGR.

So now we have some data on the levels of water in the Lake before, during and after.

What does this tell us?

Well, the simple inescapable conclusion is that the Sensex has delivered extremely disappointing returns ( even worse when you adjust for volatility) over the past 10 years and even those disappointing returns have been made to look good mainly because of the returns of the preceding four years.

That is extremely telling because it is telling us that large companies have probably hit a wall in terms of their ability to keep growing incessantly.

But, as my Giant Wheel Theory(GWT)  posits there is always going to be action in other parts of the market if one large part of the market becomes somnolent.

And so the action shifted to the small caps. How does the water level in the small cap lake look like?

Well, to be absolutely honest, this Lake has filled up amazingly well with a 47% CAGR in the past four years, which is probably the best four-year period of water filling this lake has ever seen.

But again what is important to see is that in the period prior to the pandemic, small cap returns were like  box office collections of Lal Singh Chaddha.

Time is also an extremely important factor here when analyzing the Lake of Returns Theory.

We have now had four years of an amazing bull market , especially in the small cap space.

As of March 2024, we are now entering the 5th year of this relentless bull.

The History of bull markets and their longevity is sobering: almost no bull market has lasted more than five years if we were to analyze around 100 years of market history. US:1967-1972; 1982-1987; 1995-2000; 2003-2007 and So on.

(How I wish they would invent a drug for perennial and permanent longevity for stock bull markets! )

And this happens simply because the Lake of Returns of any asset class cannot deliver 3x its long term returns, for beyond four or five years.

Smallcap  returns in India have been, very long term,  around 15-17%.

We have just had four fantastic years of 47% CAGR!

Can this Bull go to the 5th year and deliver something similar?

We absolutely can see that happen. It is indeed possible.

But how probable is that the 5th year is going to be equally strong?

Well, for this, I circle back to my earlier comment that the market is all about just various outcomes which have differing probabilities attached to them.

While it is very possible that we can have a fifth extremely strong year, how probable is that?

In fact , as I write this, it occurs to me that there is a damn good reason why we have a Bull as the animal depicting a strong uptrend in stock markets, and not a horse.

A horse is meant for long distance running,  at high speeds.

A Bull is simply not built for such endeavors. Physiologically, it is far too heavy to run too fast for too long. It will tire and tire within a fairly finite period of time.

The small cap bull has delivered far beyond what we thought it would.

This 4-year old Bull is no longer young in its legs and hardy in its heart.

The matadors are all out there with sharpened stilletos, inflicting scars on its hide: SME scams, Regulatory warnings, RBI crackdowns, funding winters, et al.

Let me put it this way: The 5th year of a bull market is akin to batting on a 5th day turning track, against Tausif Ahmed and Iqbal Kasim in Bangalore, 1987.

It will require the technique , ie, skill of a Sunil Gavaskar to navigate this period of play.

A style like Krish Srikanth's, visible luck, invisible skill, is simply not going to work.

The Game of Luck just got over.

The Game of Skill begins now.

Let me end on an optimistic note, though:

"Allah ke bande hans dey, Jo bhi ho kal phir ayega"

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.