Indian financial markets are in doldrums and a complete mess. There seems to be no future for the Indian economy. ATLEAST as per what the news media has to say. Let us get to the line of events that have happened in 2018 & 2019, that has led to ripples on financial system and markets.
- IL&FS Scam: IL&FS, an AAA-rated investment NBFCs defaulted on its loan. The reason for the default was the poor governance and business practices observed by these firms. This led to a loss in confidence in other NBFCs or banks irrespective of their credit rating or financial position enjoyed. Bankers/lenders became cautious and tightened their fist. This led to a collapse of financing to select small cap companies.
- Many episodes of fraud came to daylight due to illiquidity. Then came governance slippage in Sun Pharmaceuticals vide whistleblower report. This shook the confidence of investors as it was a large cap company widely held by investors.
- The year started with huge selling pressure in companies that had their promoter shares pledged for loans. Lenders started selling off shares marked against loans to build up liquidity.
- Then there was a new chapter in Yes Bank (supposedly known as next HDFC Bank) reporting jump in NPA numbers and many of it from not so good quality borrowers. And the bad loans kept rising as every big corporate (RCom, Cox & Kings) defaulted on their interest payments. This House of cards tumbled at once given the unconventional loan structure.
- Fall in liquidity across the board made lenders cautious against even auto dealers and second rung NBFCs which led to auto sector slowdown and consumption slowdown.
- Suicide by Mr. V.G. Siddhartha of Café Coffee Day created headlines and the stock was heavily beaten down. Even now it remains 565% down from the price before the news came out. On the contrary, all the consumption related businesses (FMCG, clothing & accessories) continue to enjoy high valuations. There was a flight to safety in the current environment and hence consumption stocks like HUL, Nestle was in high demand commanding hefty valuations.
The point worth noting here is- it’s not about the economy but about the individual businesses. These businesses are going down because of various reasons like an unviable business model, poor corporate governance, etc. and undoubtedly they are affecting the overall economy. However, not necessarily the entire economy would collapse because of these.
Also, history suggests that there is no direct correlation between stock prices and GDP growth. Look at Figure 1 below. Similarly, there is no correlation between stock prices and earnings growth. Prices are not directly correlated because they are driven more by “sentiments” which is an emotional aspect.
As highlighted above, the year 1996-97 lodged a negative change in the growth rate of GDP. Still, the market rallied up to 16%. Similarly, from 2012 to 2016, there was no positive change in GDP rate. Still, the market rally continued throughout those years giving 25% returns.
As highlighted above, from the year 2000-01 to 2003-04, the earnings growth of Sensex has been negative. Yet, the market rallied throughout those years. This shows that there is no direct one on one correlation between the two. These movements suggest that the trend is certainly unpredictable and hence cannot be timed.
Let us look at it from another perspective. Equity as a whole consists of less than 50% of overall wealth for most of the individual investor portfolios. It could be higher or lower but for most of the common individual investors, the number ranges somewhere between 1% to 25% depending on the risk appetite and financial situation. To let this portion of equity earn some return, it is important to stay invested through the ups and downs of the businesses. The typical problem done by an investor is, they try timing the market – entering and exiting whenever they feel is the right time.
We studied the historical monthly Sensex returns from January 1992 to November 2019. We found that if you invested in Sensex, you would have earned 12% CAGR in these 26 years. However, there were only 12 best months that contributed to this return. Assuming you put Rs. 1 lakh at the start of 1992 what would be your return in each of the cases:-
As per the above figure, if you were invested from 1992 to 2019, you would have been invested in the market for all 335 months. This would have given you a 12% return. If you missed the best 6 months of those 335 months, your return would have been equal to the FD rate of 6%. And if you missed the best 12 months, your return would have been only 2% which is less than even FD return.
Now, the best return giving months are randomly scattered in those 26 years and obviously known only in hindsight. Hence, the only way to make the best return is to stay invested in the markets and not try to time the markets.
In a nutshell, despite the market situation or the noise created about the economic downturn, it is important to stay invested in the markets to make good returns over the long run. Since we cannot predict the future, we need to stay invested throughout to benefit from the highest-earning periods in markets.
This reminds me of a quote- Be fearful when others are greedy, and be greedy when others are fearful.
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