Share Market Worry: Can Earnings Return to Pre-COVID Level Soon?

In the long term, stock prices can only sustain and grow if the underlying companies/economies are doing well.

Updated
Opinion
5 min read
In the long term, stock prices can only sustain and grow if the underlying companies/economies are doing well. Image used for representation.
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I agree that only God and liars can time the market. But are there ways to protect your portfolios from such excessive falls? The recent sharp correction was not due to the coronavirus crisis alone, it was mainly due to extremely elevated stock prices, without any support from the real economy.

Equities have been highly overvalued since 2016-17. The reason they were able to sustain these valuations until January 2020 was because market participants were hopeful that companies would generate enough returns in the future, to justify buying them at higher prices. But the global coronavirus lockdown killed that hope, and the markets went down in free fall.

In the long term, stock prices can only sustain and grow if the underlying companies/economies are doing well.

We must understand that the Indian economy was peaking even before the COVID-19 crisis hit.

‘Economy Never Really Recovered Post Demonetisation & GST’

Let’s look at some of the warning signs:

  • Late business cycle stage. The last economic expansion from 2009 till January 2020 was the longest in history. Periods of intense growth are followed by contraction. The last crisis was triggered by excessive debt in 2008, and instead of cutting down on debt, companies only increased it on the back of loose central bank policies. Meaning there was too much free money available without effective utilisation.
  • If you spoke to large business owners in Delhi, Mumbai, Gujarat, etc in different sectors in 2019 and simply asked them if they had been making money? Most of them said ‘no’ (barring one or two sectors like chemicals, IT). If all sectors and businesses are not making money, there is something wrong. The truth is that the economy never really recovered post demonetisation and GST. Companies were also failing consistently to deliver on earnings and targets. Plants were not running on maximum capacity utilisation, demand was deteriorating, payments were being delayed, defaults were increasing, there were almost no new job creations, or any significant hikes in salaries (all indicating that all companies in the economy were not in the pink of health). Forget companies, the government's current account deficit was getting out of control, and the government was not releasing payments for already completed projects.

‘Safe Havens Like Gold Start Rallying When Risk Builds Up In Other Assets’

  • The stock prices had been making new highs every now and then since 2018. Ignore the prices, let’s look at valuations: one of the most easy to understand valuation metrics is the price to earnings ratio. The PE ratio for Nifty is a band between 12-30 showing how cheap or expensive the overall market is. High PE = Market expensive, and Low PE = Market cheap. The best times to buy are when the PE is between 12-19. The PE went as high as 29.9 in 2019! Meaning companies were not earning enough to justify their stock prices.

Why Did Stock Prices Fall Sharply In Feb-March 2020?

  • Yield curve inversion is one of the most reliable indicators of recession. It got triggered in March 2019, for the first time since mid 2007 (last bubble fall).
  • Gold was steadily getting higher and higher, and had by far the best year in ages – around 24 percent gains in 2019 alone. Safe havens like gold start rallying when risk starts building up in other assets.

The divergence between the real economy and stock prices had to end at some point by either of the two things happening:

  • Either the real economy would bounce back strongly and stock prices would be justified, OR
  • The stock prices correct significantly and start reflecting the reality of the base economy.

The coronavirus pandemic was the perfect catalyst to trigger the latter, and hence stock prices fell sharply in February/March 2020. While investors saw significant wealth erosion, such a correction is healthy in the long term, because it gives birth to a new economic cycle.

Always Wise to Re-Assess Your Risk

As investors, it is impossible to eliminate the risk of the market from your portfolio. Nobody can get it 100 percent right, but there are a few things you can do:

  • Track Broader Market Valuations. Mean reversion happens. Period. Post this crash, Nifty50 valuations reverted to their long term average of 19 PE from an all time high of 29.9. If valuations are extremely expensive, reduce your equity exposure. What stock or mutual fund or PMS you buy will make 20 percent of the difference to your overall returns. What value you buy them at will make 80 percent of the difference. Your investment strategy should be a function of both your financial goals and the broad market valuations. Blindly following any one of them can lead to severe pain in the future.
  • Re-Assess Your Risk. If you are a long term investor in equity markets, there is always a chance of a large drawdown (more than 30 percent). For most investors, the risk in the equity markets comes from getting caught off guard when this happens, because they aren’t prepared to stomach this fall, and their asset allocation is not in place correctly. So, is the equity game not worth playing? Definitely not so. Because equity still provides one of the best returns in the long term, provided you know the rules of the game and can plan your risk management accordingly. Some investors will never return to the equity markets because of their 2020 experience, but that would be an even worse mistake than losing money in this fall, because it means you sacrificed all the returns that you could make over a lifetime just because of the scare of 2020.

Keep An Emergency Fund, The Size of 6 Months Worth of Expenses

  • Get Help. Although technology makes DIY investing seem very easy, don’t be penny-wise, pound-foolish. If you know of a good advisor, use their help to understand and control risks. Investing is not a one-time activity. It is a full-time job, hence, financial advisors exist. Chances are you will hit fewer roadblocks on your wealth creation journey if you have a good advisor. The problem is in finding and recognising a good advisor. A simple rule of thumb: never use your banker as your financial advisor. They make the worst advisors in my experience.
  • Keep Your Investments Simple. You should not be using complex investment instruments. 5-6 mutual funds are all you need to create a complete portfolio, no matter what the size of your investment is. If you hold more, reviewing and rebalancing becomes very difficult in the future. Divide your portfolio into 3 simple buckets:
  • Emergency Funds: Your emergency fund should be the size of your 6 months expenses. If you do not have this, create one immediately in liquid funds.

Markets Have Corrected Significantly, But When Will Earnings Return to Pre-COVID Levels?

  • Debt Funds: Get rid of credit risk debt funds from your portfolio. Smaller companies will find it harder to bounce back from COVID-19 and might default on principal and interest repayments, leading to a low/negative returns for your investments. Stick to AAA quality funds, preferably in 3 months-3 years space, and hold till maturity.
  • Equity Funds: While the markets have corrected significantly, it is not known when the earnings will come back to pre-COVID levels. It is possible that the market has bottomed, but it is also possible that we might see prolonged pain. Don’t rush in, stagger your investments over the next 6-12 months in quality multicap funds, and do not invest money you need in the next 3 years in the equity markets.

(Panna Bhandari is Founder, Emerald Investments, Ahmedabad, Gujarat. She tweets @Panna_Bhandari. This is an opinion piece and the views expressed are the author’s own. The Quint neither endorses nor is responsible for them.)

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