As we come to the end of 2020 all we can say is that this was an extraordinary year. A lot will be said and written about what happened in the year 2020 however I will not dwell on that and instead comment more on how things stand right now and what could lie ahead. I will try and not be a forecaster as most forecasts tend to fall flat but more about what we should be ready for to make our investment strategies
The fall and recovery of the year 2020 is unprecedented. Who could have imagined in March that markets will end up by 15% for the year for the broader indices and 24% for the midcaps. This was also a record year where globally Cryptocurrencies, New Age Technology Stocks as well as Clean Energy focussed companies did very well. These assets are now hugely overowned across the board. Bitcoin Quadrupled in the year and as is usually the case the more the rally the more the bullish calls. The huge money printing and Fiscal spending globally to avoid a potential depression seems to have achieved its aim.
Economic recovery and corporate sector performance picked up more strongly than expected driven by low interest rates, cost cutting as well as pent up demand across some sectors. In some sectors the recovery seems to be sustainable and in others it seems to be patchy. 2021 will be a good test for the recovery play.
As we step into the year 2021 the scourge of Covid 19 continues unabated globally although in India we peaked out and seem to have avoided the second wave successfully ( again something which is rare). The hope now is that with the Vaccine roll out imminent even in India we will be able to end the scourge sooner than later. So this year should be better for life in general. However the key point we need to debate is whether the stock markets have discounted a large part of the normalcy trade or not.
The facts as they look like at this stage are that the Indian Economy will contract by around 7% this year and recover by 10-11% next year. Normally corporate earning growth is highly leveraged to economic growth. However in these extraordinary times the fall in earnings that was expected this year actually was much lower as margins expanded substantially driven by lower input costs, cost cutting in general and lower interest costs. The projections for next year are for an earnings growth of around 30%. This is a tall ask and happens every year when at the beginning of the year most analysts are very bullish and slowly we see earnings expectations getting down graded. With the assumption of a 30% earning growth markets now trade at around 23X one year forward earnings. Under a more reasonable assumption of a 20% earning growth the PE is near 25X which is almost a record high leaving little chance for a rerating.
The key is the liquidity. We have seen Rs 170000 Crores flow into the Indian Markets in 2020. Out of this 67% was in the last two months itself. Globally cash positions of Fund Managers are at a multiyear low, Emerging Market allocations at a record high and short positions on the US Dollar at a record high. The degradation and decline of the US Dollar driven by US Twin deficits of the Fiscal and Current Account deficit has led to strong risk taking over the last few months. It will be interesting to see the new administrations take on the US Dollar as a continuous decline will challenge its reserve currency status. Strong and short pull backs in the US Dollar could create volatility in risky assets.
Although valuations are at all time highs across many markets the counter argument that is given is that interest rates are also at all time lows and relative to the cost of capital adjusted for equity risk premium the market valuations are not as high as they look. However the challenge in that argument is that it assumes that inflation will never pick up and interest rates will remain low for a prolonged period of time. Many savers and investors are facing this challenge. In most developed markets savings bank rates are near zero, zero or below. In India they are at 3-3.5% and from the perspective of many it fails to beat inflation at a time when incomes are generally in stress. This prompts risk taking either conscious or forced. Valuations are extended not only in India but in most other markets. For example US Market valuations are at 26X 2021 expected earnings, almost at the peak of where they have been historically.
The debate which I also face in my mind is that if governments like in the USA can borrow cheap as the Federal Reserve keeps interest rates ultra low without prompting inflation to come back. That is Goldilocks right? However factually the more is the borrowing today the more it compromises growth in the future as any money borrow firstly has to be repaid and secondly also carries a refinancing risk in the future. For example the Debt to GDP of the USA was 65% in the year 2008 prior to the financial crisis. It stands at 135% today with a possibility of a further increase going forward. This requires interest rates to remain very low for prolonged periods of time to avoid becoming a fiscal crisis.
The positives for 2021 are that the real economy will do much better and when the real economy grows there are always possibilities of investing to make money. When this comes along with low interest rates then the operating leverage of many companies increases hugely. As such winners of 2021 might not be the traditional companies that people believe will do well but might be from sectors like Real Estate, Construction & Infrastructure, Commodities etc. Recovery plays will still be available and are cheap to where they should be. This includes stocks from Hotels, Aviation, travel accessories, multiplex operators, entertainment companies among others.
There are two sets of investors and traders in the markets today. The first category is high risk takers who are not bothered about the downside as either they have not see a big bear market or they are in a false sense of complacency. These traders and investors have done very well for themselves in 2020 as anytime you bought after March you made money and any time you sold you made a mistake. On the other hand there are wary investors who have either stayed on the sidelines or have been pulling out money. These are the frustrated set right now as they think they have missed the bus. However there is nothing like missing the bus in the stock markets, there is always another bus that comes.
In Conclusion I would say that 2021 will be a year where we will mostly get returns that should be in single digits or low double digits as far as the overall large cap indices go. This is not a projection but an expectation based on which I will be devising my investment strategies. However contrarian and deep value stocks or those who have a technological advantage or in new generation sectors can do much better. As such the potential of achieving high returns with the right stock bought at the right time is high. Stocks deliver returns based on outperformance versus consensus expectations. We need to identify such companies. Good, high quality companies where expectations already are very high are unlikely to deliver strong returns this year. While 2020 was about buying quality stocks cheap as everything got beaten down the same play is not available this year. As we end the year the markets have not been as overbought and bullishness so high in many years. Patience as such will be rewarded.
I end with two comments
- A new all-time high in a stock means every shareholder is making money. That makes them less interested in selling, which sends prices higher still We are at a point where investor psychology dominates any corporate/economic data Stocks can go up as long as people want to buy them.
- he Dunning-Kruger effect is a cognitive bias in which people with low ability at a task overestimate their ability It observes that people who are the most ignorant about something will be the least aware of their own ignorance They have the highest sense of false confidence. (Visible in traders/retail investors today)
OVERALL 2021 WILL BE TOUGHER FOR INVESTING BUT CAN BE EQUALLY REWARDING WITH THE RIGHT SET OF STOCKS.