Not long ago, stock markets around the world were rallying to scale record highs. The COVID-19 crisis has punctured a global rally and thrown it out of gear. We are witnessing a trough like none other in the history of the stock markets.Share prices around the world have plunged. They have shed gains made over the past three years.
However, financial markets go through cycles. That fundamental belief is still out there. Analysts are busy putting together data and figuring out ways to find the so-called ‘bottom’ of the market. In the US and Europe, things are still unfolding. Rich countries are capable of managing their economies due to more robust economic fundamentals and low population.
They can afford to print money and provide it to tide over the crisis because inflation is zero.
India cannot replicate the action taken by American or other wealthy countries. India has much higher retail inflation, and hence, interest rates. The other fundamental difference between other significant economies and India is also the growth factor. Economic growth in India is likely to be around 2.5-3 per cent range in the worst-case scenario, according to most predictions. The same analysts suggest a contraction of 4-5 per cent in prosperous economies.If historical data is to be believed, the S&P BSE Sensex is still 15-20 per cent away from the depths it touched during a previous major crisis. We will try to explain three essential factors.
Market cap to GDP ratio
Market capitalisation or market cap is the share price multiplied by the equity shares issued of the company. A simple ratio people look at is the market cap as a percentage of the Gross Domestic Product of a country. The long-term average for India is about 60 per cent. Currently, it is closer to 50 per cent. However, that is still above the bottom of 30-40 per cent reached after the dotcom burst in 2001. The market structure today and about 20 years back is a bit different. Foreigners own a sizeable amount of nearly 40 per cent of the $800 billion market value of traded shares. Domestic mutual funds and LIC together own about $200 billion worth of equity shares. Foreigners are selling to avoid owning risky emerging-market assets. Indian mutual funds and other institutions have only Indian stocks to buy. Over $1 billion flows into equity-linked mutual funds each month in India. That money has to find the right price at some stage to make an entry.
Price-to-earnings ratio
That is the most common multiple used to compare the value in equity markets. It is the multiple of the share price to the net profit per share or earnings per share. It is usually calculated for an index like NSE Nifty or S&P BSE Sensex. The cumulative share price of all constituent stocks in the index is divided by the cumulative earnings per share of those companies. The long-term average of the price-earnings multiple is 18 for the Sensex. We are currently at 17. The bottom touched in the worst crisis was 10, and was 25 at the peak. As the number suggests, we are right in the centre. As share prices fall further, we will move closer to the bottom. Again, that indicator indicates a further downside.
Yield gap
Now, that is a complicated number. The earnings yield is the inverse of the price to earnings multiple of the benchmark indices like the S&P BSE Sensex or Nifty. The yield gap is the difference between the 10-year government bond yield and the percentage of inverse price-earnings multiple. Near the bottom, it is usually negative. That means the rate of inverse PE is higher than the 10-year bond yield. Currently, the 10-year bond yield is equal to the inverse earnings multiple. At the bottom, during the global financial crisis, the yield gap was negative 3 per cent or 4 per cent. At the peak during the dotcom bubble of the early 2000s, it was well above 5 per cent on the positive side. The historical data suggests that we are still some distance away from the bottom touched during the early 2000s or 2009s.
Historical data is only guidance. It is not a guarantee that markets would follow that trend. If the government takes proactive steps after the virus is contained and the economy starts to produce and consume goods and services faster than expected, share prices could witness a ‘V-shaped’ recovery. However, if that happens slowly, we could be seeing a ‘U-shaped’ revival. Slow progress towards an upcycle.
(The writer is editor-in-chief at www.moneyminute.in)
