Privileging the hypothesis: Are we staring at an extended phase of subdued market returns?

In the past, market cycles tended to balance the two phases of stock performance, aligning earnings growth with index appreciation. This dynamic, now, appears unsettled

If one were to liken life and the financial markets to a real-time criminal investigation, they would appear notably uninteresting. When observed in real-time, a substantial proportion of inquiries lack direction, appearing considerably haphazard and inefficient. Yet, upon retrospective analysis, they exhibit a remarkable linearity and adhere to a coherent narrative.

However, there exists a concept within criminal investigations wherein all participants become overly focused on a singular theory. In such instances, a shared false assumption has the potential to undermine the entire investigative process. This phenomenon, ladies and gentlemen, is commonly referred to as 'privileging the hypothesis.'

Rory Sutherland discusses a pertinent case in his book, Alchemy: The Surprising Power of Ideas that Don’t Make Sense. It concerns the trial of Amanda Knox and Raffaele Sollecito for Meredith Kercher's murder in Italy. Investigators fixated on a theory that the perpetrators had engineered a staged break-in to resemble a burglary gone wrong. This conviction stemmed from apparent evidence, such as broken glass outside a window and a lack of footprints. Notably, an alternative entry point existed through an exposed upstairs window.

In the investigative process, a critical realisation emerged belatedly: the shattered window's purpose was not primarily entry but rather to create significant noise while affording a strategic escape position. This tactic provided the culprits with assurance that the vicinity was deserted, enabling them to later utilise the higher-floor window for house entry without detection.

Within a meticulously designed system, a component typically fulfils a singular, precise function. However, in intricate, evolved systems like human behaviour, elements possess multifaceted utility contingent on contextual interpretation.

Some individuals discussing stock markets often employ reverse explanation, a tool facilitating post-rationalisation. The critical question, though, is whether it helps understand things in real time.

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Consider the present market conditions. In August 2023, the US labour market cooled off. Investors now anticipate a Goldilocks scenario, wherein inflation is managed without inducing a recession. Economists at Citi wrote, "If the Fed could have put together their ideal employment report, it would look something like today.” Following the release, the futures markets cut the probability of a rate rise at the November meeting from 50 percent to 40 percent.

India's current situation is favourable, marked by increasing labour force participation and productivity gains, driven by PLI initiatives. Coupled with ongoing political stability, this is expected to attract greater international and domestic investment, potentially leading to a re-rating of India's market multiples, with markets interpreting all news positively.

In the initial six months of CY2023, Indian promoters have divested twice the value of stock compared to the five-year average. This development is seen as positive, as it increases the available float in the market. Recently, a private equity firm sold over 25 percent stake in a tech business, the stock rose 10 percent that day - indicating relief over the overhang resolution. Whether a company reports strong or weak financials, both scenarios are often interpreted positively. Positive results are naturally good news, while negative results are construed as "the worst is now in the price," suggesting that the downside is already factored in by the market.

Indian market participants seem to be privileging the hypothesis that India's long-term prospects warrant immediate valuation. Permit me to introduce an alternative set of hypotheses.

Firstly, there's a notable lack of attention to crude oil prices recently, which have surged by $16 per barrel since June 2023 lows. Given India's annual import volume (approximately 1.7 billion barrels), this trajectory implies an additional annual expenditure of nearly $30 billion.

This comes in the context of India's foreign exchange reserves declining by nearly $15 billion, reaching $595 billion since their peak in early July 2023. Furthermore, the interest rate differential between India and the US, currently at only 100 basis points, is at its historical low. This situation is concerning, given India's short-term external debt, amounting to $274 billion according to the RBI's records as of June 30, 2023.

Continuing our analysis, tax collection data for four months of FY24 (April to July 2023) reveals a lacklustre performance. Direct tax collections have shrunk by 1 percent year-on-year, and corporate tax collections are down 10 percent YoY. Concurrently, total expenditure has surged by 23 percent YoY, predominantly due to a 52 percent YoY increase in capital expenditure. Consequently, these four months have already witnessed over a third of the full-year budget deficit, whereas in the past two years, it was closer to 20 percent of the annual deficit.

Lastly, after four years of above-average rainfall, there's now a seasonal deficit, especially in the East (16 percent below normal) and South (17 percent shortfall). This could impact the current rain-fed rice-driven season (Kharif, sown in July-August, harvested in October), potentially leading to stagflation. New Delhi might allocate an additional Rs 1 lakh crore to address this in an election year, challenging fiscal deficit targets and requiring increased borrowing, particularly with a narrow 100 basis points differential between the repo rate and the Fed Funds Target Rate.

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Over the last five months, over a quarter of listed stocks with a market capitalisation exceeding Rs 500 crore have surged by over 50 percent. This seems to reflect a bias towards privileging a certain hypothesis. Nonetheless, the current scenario bears an unsettling resemblance to 2018. Policy rates, G-sec yields, and GDP growth are comparable, but inflation and fiscal deficits are elevated.

We have consistently maintained that a great company and a great investment are two different things, as various sectors and stocks undergo cyclic patterns. When identifying a business capable of sustained earnings growth over many years, initial market enthusiasm often drives rapid share price appreciation, detaching it from earnings growth. This marks the first phase.

Subsequently, an extended period of earnings alignment follows, characterised by modest stock returns despite robust earnings expansion, constituting the second phase. During this stage, a company remains fundamentally strong, with earnings growth and return metrics surpassing the cost of capital, yet it transforms into a suboptimal investment. For stocks, it is a foregone conclusion that whereas earnings can consistently compound, share prices rarely, if at all, do.

In the past, market cycles tended to balance the two phases of stock performance, aligning earnings growth with index appreciation. This dynamic, now, appears unsettled.

While India's long-term potential is undeniable, widespread bullishness suggests that once the current exuberance subsides, we may experience an extended phase of subdued overall market returns, despite India's fundamental strength. The company (India) may remain strong, but its share price (Index) could face a period of underperformance.

We could be heading towards a market scenario resembling the post-2018 period, marked by lower returns (65 percent in five years versus 265 percent in the past decade). Particularly concerning is the current exuberance in small and mid-cap stocks, potentially mirroring post-2018 dynamics when the small-cap index dropped over 50 percent between January 2018 and March 2020.

As a result, judicious sector, market cap, and stock selection become pivotal considerations in the current market landscape.