Nifty @10,800: Irrational exuberance or rational expectations?

Stock market history is replete with instances of manic-depressive market movements. Markets, often, overreact: both on the upside and downside. Spectacular bull runs followed by catastrophic crashes are normal events in the long history of stock markets. Yet, the last 150 years of financial history tells us that stocks have outperformed all other asset classes, by a wide margin.

Notwithstanding this long-run history, the short-term gyrations–‘irrational exuberance’ and devastating crashes – can be unnerving and confusing for investors. Bubbles can be understood only in retrospect. So, how should investors navigate this turbulence while participating in this rally?

We should be clear about the paramount driver of this rally. The consequences of COVID-19 are even now profoundly uncertain. Market legends like Warren Buffet, Charlie Munger and Ray Daleo are confused. But the market is not, it is climbing all walls of worry.

Nasdaq has been setting records and Dow and S&P 500 are up nearly 40 percent from March lows. The Nifty, too, is up more than 40 percent from March lows. The trend is global.

It is evident that this global rally in stocks is driven by unprecedented liquidity injected into the global financial system by central banks led by the Fed.

The Fed alone has injected around $3 trillion since April, bringing interest rates to historic lows. When too much money chases too few stocks, we have spectacular rallies in markets. Is this irrational exuberance? Or, is the market, in its collective wisdom, sending a message that is not yet discernible to all?

Some sectors and stocks have become the darlings of the market. Resilient segments like telecom, which is a clear winner in COVID times, non-leveraged segments like IT, defensives like FMCG and pharmaceuticals, which got a new lease of life thanks to COVID, are the darlings of the market now, and, the exuberance in these segments is rational. But is there value in these segments? Or, do the beaten down segments and stocks offer better value?

It is clear that many businesses will not survive this crisis. The highly leveraged ones are extremely vulnerable. Many, like travel, tourism and hospitality will find the going very tough for a long time.

It is also clear that many companies will emerge stronger after the crisis and continue to grow. Investors should focus on these guaranteed survivors.

Early trends, like the results of HDFC Bank, indicate that the big are getting bigger and stronger. Flight to quality is normal during crisis. Quality market leaders are increasing their market shares. And, this trend is likely to gather momentum, going forward. So, it makes sense to remain with the darlings, even if there is a risk of short-term price correction.

The panic reaction to the pandemic at the end of March and the bear hammering in mid and small-caps and segments like automobiles led to massive price erosion in some of these segments.

The mid and small-cap indices are way lower than the highs reached in January 2018. But investors should not fall into the value-trap of mid-small-caps. Investment in this segment should be done, ideally, through the mutual fund route.

Globally, stock valuations are on the higher side. S&P 500 is trading at trailing PE of 24 and the Nifty is currently trading at trailing PE of around 24. Even though the historically low interest rates warrant higher than normal valuations, the uncertainty surrounding COVID cannot justify lofty valuations.

With valuations at higher levels, negative news can trigger capital flight and sharp market corrections. Therefore, investors need to be agile and fleet-footed in this market.

Globally, markets are discounting sharp recovery in growth and earnings in 2021. Will this happen? How long will interest rates remain low justifying the high valuations? Only time can tell.