Saurabh Mukherjea
Here Comes the “Final Frenzy”, Jeremy Grantham foresees a “melt-up”.
In the first week of 2018, Jeremy Grantham of GMO has made the case for a ‘melt-up’ or ‘end phase’ of the bubble in the current US stock market. He says that this bull market in America will end within the next 6 months to 2 years: “I recognize on one hand that this is one of the highest-priced markets in US history. On the other hand, as a historian of the great equity bubbles, I also recognize that we are currently showing signs of entering the blow-off or melt-up phase of this very long bull market.”
Mr Grantham’s views prompted us to look into the evolution of three famous bull markets - the US bull market of the 1990s, the US and Indian bull markets of the noughties - and study the current Indian bull market. Based on our study of these three bull markets, we find that bull markets typically demonstrate three distinct phases.
Broader rally - In the first phase of the rally investors usually bet on four to five sectors to beat the benchmark. It is during this phase that ‘Champion’ sectors and companies are identified. The typical duration of this phase is 3-4 years.
Temporary pause - Then comes the second phase which is the “temporary pause” phase i.e. when markets pause for 10-15 percent correction driven by specific fears such as Asian financial crisis (1997), the P note crackdown (2007) or the fear of a collapse in China (2015).
Effectively, during this phase the investors pause to reassess the ‘Champion’ sectors.
Narrow rally - The final phase is the “narrow rally”. In this phase, of the ‘Champion’ sectors that kicked-off the rally, only a few [one to three sectors] are still able to rally. Investors bet on a new economic paradigm which (they believe) will transform these sectors. The ‘Champion’ sectors then become bubbles as investors bet that all economic activity will converge into them. Post the narrow rally, these ‘Champion’ sectors tend to severely underperform the markets.
What are the lessons from history for the current bull market?
The market (as represented by the top 1000 stocks) was up 61 percent cumulatively from September 2013 till September 2016. The market paused in the months leading up to demonetization in November 2016, a pause of four months from September 2016 to December 2016.
The end of demonetization signaled the end of the pause. From the pause to date, the market (top 1000 stocks) has risen 52 percent cumulatively.
While it is hard to know how long the final phase will last, historical equity markets under our study have lasted on an average 2 years in their respective final phases, thats is, post the pause.
Rapid PE expansion - both for the overall market and for the champion sector - tends to be a clear sign that are in the final stages of a bull market and we are seeing that both for the Sensex PE (exhibit below) and for the Financials sectors PE (see exhibits further on in the note).
In terms of sector performance, the Financials sector outperformed in both the phases, that is, from the start of the rally up to the pause and post the pause (exhibits below).
Furthermore, the sector qualifies the two markers of a bubble as specified in the previous sections:
1. The sector with a bubble tends to gain market cap share rapidly in the final phase of a bull market. In the case of the Financials sector, its total market cap share has risen from 16 percent on September 2013 to 23 percent now.
2. 12 month trailing P/E ratio of the sector has expanded materially over the course of the rally – from 8x on September 2013 to 30x now.
Our conclusion is that the current Indian bull market (which has delivered cumulative returns to date of 145 percent over the last four years) is all set for a final frenzy given: (a) post the “pause” in the closing months of 2016, the market has rallied strongly for a year and history shows that bull markets last for two years post the pause; (b) in the final stages of a bull run, the “champion” sector in the rally rockets up and the Financials sector (PE multiple up 4x in the last 4 years) is rising in such a fashion; and (c) in the closing stages of a bull run, the market PE shoots up – the Sensex’s trailing PE has risen from 17x to 24x in the past 12 months.
Disclaimer: Saurabh Mukherjea is the CEO of Ambit Capital. His next book “Coffee Can Investing: The Low Risk Road to Stupendous Returns” will be published in February. The views and investment tips expressed by the expert on moneycontrol.com are his own, and not that of the website or its management.
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