Over the past few years, India’s equity markets have seemed to be in a bit of a Schrodinger’s Cat situation. The year 2013 saw India’s economy being a part of fragile five post which Narendra Modi led BJP Government saw a thumping victory in the elections. Just when things were looking to get back on track, December 2016 saw Demonetization that created another wave of shock.
Warren Buffet has rightly said that markets can remain irrational more than investors can remain solvent. India’s equity markets saw an influx of massive liquidity which saw nifty and Sensex going up, contrary to the investor’s expectations of there being blood on Dalal street. 2020 saw equity markets going down substantially till March and from there on prices have recovered sharply.
So what does the Schrodinger’s Cat mean:
‘In simple terms, Schrödinger stated that if you place a cat and something that could kill the cat (a radioactive atom) in a box and sealed it, you would not know if the cat was dead or alive until you opened the box, so that until the box was opened, the cat was (in a sense) both “dead and alive”.’
Said differently, in a situation with heightened levels of uncertainty due to lack of information or insight (box is closed) it is possible for two opposing states to exist – one where the cat had been killedby the device, and one where the cat survived. Who is to say until the box is opened?
I use this analogy because in 2020 it is virtually impossible to have any certainty around how the future will unfold in the short to medium term. That said, this type of environment is conducive to the wild swings experienced in markets this year full of rapid bear markets, bull market rallies, corrections, and everything of the sort. In this case, Schrodinger’s Cat is the stock market, and the device(s) placed in the box are obvious: COVID-19, US election, stimulus, etc. Just think about how much speculation and commentary there has been about the short and long term economic consequences of COVID since the India first went into lockdown in March 2020.
Advanced economies such as France, Germany, etc… have been witnessing the dreaded additional ‘wave’ of COVID in the fall before we had even finished dealing with the first wave. This has given rise to a boom in speculation of alternate futures. There can be a scenario where India doesn’t get a second wave because we have developed herd immunity or our worst fear of subsequent lockdowns are imposed again.
In tandem with the daunting reality of Schrodinger’s Box finally being opened is the role of “TINA” (there is no alternative) for growth stocks. As OSAM Research Partner Jesse Livermore (pseudonym) recently wrote:
‘If investors are sensitive to valuation, rising prices will reduce their desire to allocate to equities. But it’s difficult for valuation to gain traction as a consideration in the current environment. The relevant value proposition that investors have to consider is an awkward proposition that pits positive-but-historically-depressed earnings yields in equities against zero yields in everything else. Rising equity valuations cannot easily shift the balance of that proposition for at least two reasons. First, equities can produce attractive returns even when purchased at elevated valuations, provided that they stay at those valuations—and in the current case, they very well might. Second, the alternative proposition—earning a negative real return for an indefinite period of time while others continue to make money–is simply unacceptable to many investors.
We refer to this logic as the logic of TINA —” There is No Alternative.” The logic is sound, but it has limitations. Equities aren’t going to rise to infinity—an earnings yield of zero–simply because the competition is yielding zero. As equities become more expensive, they become more “needy”, more sensitive to declines in buyer enthusiasm. Their neediness and dependence on continued buyer enthusiasm increases their potential for inflicting losses.
But now suppose that the price gets pushed up in a TINA chase to $100—an earnings yield of 1%. If you buy at that price, you’re going to have to remain laser-focused on the market’s subsequent response, keeping the position on a short leash and rapidly exiting if buyer enthusiasm starts to wane, because the 1% earnings yield that you’re going to be accruing is nowhere near enough to compensate you for the loss of access to your money, which is what you will have to endure if the price falls appreciably from where it currently is. If the market decides that it wants to assign a 20 P/E ratio to the security instead of a 100 P/E ratio, the price is going to fall by 80%. You’re going to have to wait a full 80 years to get your money back in earnings. Will the wait be worth the 1% spread over cash that you will have locked in? Absolutely not, which is why you’re going to have to pay close attention and make sure that you don’t get stuck in that kind of a situation.
In the same way that you are going to be more sensitive to drawdown risk as a buyer at elevated valuations, everyone else in the market is going to be more sensitive as well, which will make the prices themselves more sensitive, and the investments more risky.’
Jesse Livermore, a legend in the World of investments has a knack of making things sound incredibly simple. When you think about the above example of 100 P/E falling to 80 P/E, it sounds extremely straight forward that 100 is an overpriced number. Yet as we often encounter, reality is extremely different.
Consider Nifty50’s P/E ratio movement. It’s at 34.5 as of yesterday (November 11, 2020) is that overpriced? Should we invest at this level? Earnings yield of Nifty50 index has been around 1.30% odd. How would that play out? Let’s have a look.
Nifty50’s P/E ratio movement
We started the year with a P/E of 28.33 which is much higher than its long term average of 18. In March we witnessed a correction in prices due to unprecedented covid-19 situation and India going into a lockdown. That’s where P/E was near its long term average of 20 and at one point closed at 17.15
Since then price of Nifty50 index quickly recovered with little to no earnings growth and reach a high of 34.87 and as of this week it stands near 34 level.
At this point, many investors would argue the traditional ‘what-if’ situations of market going up, down or sideways. There tends to be a great debate with news driven approach for rationalizing that Nifty’s P/E will remain above the levels of 30 or 40. There is also a chance that 30 becomes the new 20.
This is a classic Schrodinger’s Cat situation. We have two scenarios here – price and earnings. Until we open one of them, we will come to know what’s inside them. With result season around the corner, there is some expectation of either price moderation or earnings jump.
So while expanding the lesson a bit more from the school of Jesse Livermore (explained earlier), Nifty’s P/E of 34 is around 80% higher from its long term average of 20. To keep things simple, let’s not worry about earnings yield of Nifty’s stocks. Just think about this, for Nifty to reach a P/E of 40, it will have to go up by another 28-30% (approx). The picture does look rosy when we tend to ignore the risks and merely look at rewards.
On the risk front, a P/E of 40 for Nifty stocks is an unprecedented situation. It will take a mammoth of earnings growth to really counter that level of price rise. Such an earnings growth will need to be supported in the form of consumer demand and India rising to new levels of GDP. Growth in bank credit will have to minimum double from here. It’s not an overnight journey.
Rome wasn’t built in a day! Yet, Hiroshima Nagasaki were destroyed in one day!
Nfty’s long term average P/E of 20 will warrant a fall of 45% (approx.) from the current level of 34.5. Now that’s a serious impact on the portfolio. At the outset, we believe that it will be easy to offset the loss as we will remain extremely calm during those times. In fact, a rational investor would really go out and buy more at that time. But do we really stay rational?
Behavior Finance has a nice name to it – stated risk vs revealed risk.
Stated risk is a form of risk we talk about while nothing is really at stake. For example, I can easily navigate traffic at the speed of 180 kmph without hitting the breaks.
Revealed risk is a form risk that our results in our behavior at the time of an event. In our previous example, while I can easily navigate but when I’m at 180 on Mumbai-Delhi Highway and there are some trucks around which are trying to overtake each other – honestly, I will be extremely worried and scared. Since I’m not very religious, yet I will chant a few mantras too.
Same is the case when we witness our investment portfolio crashing. It’s difficult to stay rational. But till the time it hasn’t happened, we can always talk about the importance of being patient and investing more when Nifty goes down.
Currently, Nifty’s P/E is in a Schrodinger’s cat situation. It’s only when the box is opened, will we know the truth. But till that time, it’s important to assess our own behavior and take appropriate risks.
Please note, that we are not recommending any buy or hold or sell your investments in this article. That’s best left to your financial goals and steps taken by you and your financial advisor towards the investments. What we are simply trying to highlight is that historically, we are witnessing a very high P/E ratio, so if you are planning to invest your money then be extremely vigilant and understand the risks associated at these P/E levels for investments.
written by Jinay Savla