Stock market tour: from trouble zone to bubble zone
The ongoing stock market rally is liquidity driven and may not last very long—have you heard this run-of-the-mill view lately?
If you read newspapers or watch business channels or talk to financial advisors, most of them are concerned about the ongoing market rally which has taken almost everybody by surprise. But before you take any decision pertaining to your investments, see through this oversimplified interpretation of facts.
Fact: The ongoing rally is liquidity driven
Oversimplified interpretation: It may not last very long
Many novice investors and even some self-proclaimed market experts use the term liquidity without getting to the core of it.
What is liquidity?
According to the Federal Reserve (Fed), asset price liquidity is an asset’s ability to be transformed into another asset without loss of value. Liquidity also implies the confidence of investors in their ability to transact quickly without exerting a material effect on prices. Based on this, former Governor Kevin Warsh of the Fed coined a new connotation of liquidity— Liquidity is confidence—in 2007.
Going by all these versions of liquidity, it’s safe to conclude that money flow and investor’s belief in the strength of stock prices are crucial factors one should consider while making any guess on the future price movement.
When valuations are cheap and global liquidity is strong, gains are high and the rally has longevity.
On the contrary, if market valuations are expensive and liquidity is low, markets witness steep losses and the bear run continues until valuations become attractive or liquidity improves. These are extremes. There can be several combinations of these two factors based on their strength.
Where do we stand at present?
At present, markets are rising in the absence of earnings growth hence, the valuations aren’t attractive; rather they are getting stretched in many cases. All arguments questioning the longevity of the on-going rally stem from depressed earnings. That said, markets have been showing immense strength, hence greed is driving investor confidence and optimism.
Well, time to remember the famous quote of John Maynard Keynes: Markets can stay irrational longer than you can stay solvent.
It’s imperative to see the quantum of money supply in the global financial system before jumping to any conclusion. Let’s not forget cash is the most liquid asset.
How strong is money supply?
In finance, there are several categories money can be classified and accounted into. They are called monetary aggregates, of which, M2 is the global barometer of money supply.
What is M2?
According to Investopedia, M1 is the money supply that is composed of physical currency and coin, demand deposits, traveler’s checks, other checkable (demand) deposits, and Negotiable Order of Withdrawal (NOW) accounts. M2 includes all components of M1 and also the near money assets such as Certificate of Deposits and T-bills among others. M1 is called narrow money and M2 is called broad money.
The COVID-19 related stimulus packages awarded in the developed markets are not just quantitative easing packages (QE) rolled out in the aftermath of financial crisis. Many experts believe, credit guarantees offered this time are unprecedented and can have a lasting impact on the financial system.
The COVID-relief packages are not only bigger in quantum (as compared to the ones doled out during the financial crisis) but their allocations are strikingly different too. For example, The Coronavirus Aid, Relief and Economic Security Act (CARES Act) accords unprecedented support to distressed industries and small businesses in the US.
Similar schemes have been launched in Canada, Australia, the UK, and Hong Kong among others. Most of the state guaranteed loans have a tenure ranging between 1 to 6 years.
Take one more example. According to the Financial Stability Review (FSR) published by the European Central Bank (ECB), the quantum of credit guarantee schemes launched by Germany, France, Italy, Spain and Netherlands has been around Euros 1,700 billion. ECB estimates suggest that as many as 60% of them could turn bad in some cases.
Hence, some experts opine that unlike previous central bank-run stimulus programs, governments have been in the driving seat this time around. The same school believes this time the stimulus is likely to go beyond inflating asset prices and affect the real economy as well. With credit guarantee schemes being in place and resurgence of local manufacturing, the deflationary era might end soon, at least in the developed economies. It will be interesting to see how much of the money created in the developed economies finds its way into emerging markets.
As far as India is concerned, the government seems to have taken a cautious stance, going by trends in the monetary aggregates. That said, India too has launched a credit guarantee scheme worth Rs 3 lakh crore for MSMEs. Recently, RBI refrained from slashing policy rates further citing inflationary risks. Perhaps, it might be preserving some ammunition for future, as some newspapers suggest.
Mutual fund inflows, which give a fair idea about domestic inflows, turned negative in July. Monthly SIP collections dropped below Rs 8,000 crore for the first time in the last 18 months.
On the other hand, Foreign Portfolio Investors (FPIs) remained upbeat on India.
After offloading holdings worth Rs 68,860 crore in March and April, FPIs have ploughed back over Rs 53,100 crore in the last four months (including the first 10 days of August).
Besides, growth and inflation trends in India, money supply, inflation and employment trends in the developed markets have become crucial factors to watch out for in the current context.
At present, there’s a mountain of expectations, a tsunami of liquidity and a landslide in earnings.
Markets are expensive but will not necessarily fall.
Liquidity is driving the markets; but that doesn’t mean, the tap will run dry soon.
As they say, for every trade there’s a buyer and a seller and a bull and a bear. Liquidity is as big a determinant as valuations, for the market movement.
Clinging to asset allocation, having well-defined investment objectives and combining bottom-up and top-down approachs in stock picking holds the key.
Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves—Peter Lynch
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