Are we in a Stock Bubble ?

We will start the topic by asking the question that should we invest in today’s market?

Whether we should follow Michael Burry pessimistic approach or believe in investors like Cathie Wood Optimistic prediction about stock market? 

Currently in the context of Indian economy we are hitting all time high in stock market which is trading above 17500. The multiple of earnings that Indian stocks are trading at higher than its been historically, all this is happening post Covid and everyone of us is scared that on the one hand the virus is still spreading through the world and on the other side of the equation we have stock market which is not going down.

Investors like Michael Burry who is well known for predicting 2008’s Housing Bubble, warning people about stock market crash very soon by basing their decisions on analyzing metrics like Market Cap to GDP ratio.

What is Market Cap to GDP Ratio?

It is used to evaluate whether a particular given market is accurately valued in accordance with its historical average. When you take aggregate of all the S&P 500 company’s market capitalization divided by the GDP you get Market Cap to GDP ratio also known as Warren Buffett Metrics.

Market Cap to GDP ratio= SMC/GDP

(where SMC stands for Stock Market Capitalisation and GDP stands for Growth Domestic Product of a country)

 Stock market experts observe that when the Market cap to GDP goes above 100 it is a sign of a crash that has happened in 90’s DOTCOM Bubble and happened in 2008’s Housing Market Bubble.

Now so many people would say hey Market Cap to GDP ratio went up so you should sit on sideline and not invest in stock market. Market cap to GDP ratio jumped 20 years high in 2021. Indian market cap to GDP is currently around 104-105%, historically it was 80% of India’s GDP, the only time it traded on 100% of the India’s GDP was in FY 2008. The reason for this high is due to Corona, in 2020 countries like USA brought trillions of cash into the economy that money came to economy like India also because of which the stock market went up because of the excess liquidity market cap of all the listed company went up (numerator of the ratio went up). The GDP of India in last two quarter have declined massively (denominator of the ratio have gone down) so the entire ratio went high.

If we compare our economy with other more efficient economies, then in an economy like USA if Market Cap to GDP is between

50-75- it is undervalued

75-100- fair valued

Above 110 overvalued

But this is not applicable to Indian economy as India has historically been an economy driven by private businesses/ family-owned businesses and we do not have access to correct information about the business which led to miscalculation of earning and other major metrics. 

Also as per Aswath Damodaran, a renowned professor in the Stern School of Business at New York University, Market Cap to GDP is a bad metric to base our investing decisions specially during Covid situation.  In one of his interview he explained Since 2020 was an exception and most of the businesses were closed for atleast two quarters hence we are in an unusual times and in this situation Market Cap to GDP ratio will appear bloated so cannot be treated as a reasonable indicator. But we can make the sense of this ratio in a way by just looking at what that ratio was before the Covid period. If it was high then, then we can treat it as high now and vice versa.

The more acceptable metric to investor is price to earnings ratio i.e PE ratio, it is growth indicator and can be shown as below

                                         PE Ratio= P/E

where P (Numerator) stands for Price of the stock and E (Denominator) stands for Earning of the stock

      Currently nifty is estimated to be trading at over 20 times to the earning of FY 2022 which means the price of the stocks are higher than its earnings, historically we have traded probably maybe 17 times at best so we can say it's currently so high.  If we analyze the reason we can simply arrive at the conclusion that for majority of companies the earnings have gone down in 2020 because of Corona virus, people were not buying products a lot of companies were not producing, some industries like travel and tourism completely shut down, cinema companies like PVR, INOX and other multiplex chains had to close down their entire business. People in favor of doing investment in the stock market give explanations that when in 2021 and 2022 the earning improves, and everything get normalize the PE ratio would automatically come down (because the denominator would go up) so we do not have to worry about high PE ratio.

       If we trust investors like Cathie Wood's prospective who is well reputed investor of USA and has earned a lot from the stock market, she is very bullish about the market and optimistic for the future. She has explained three major points of the economy

     ·   Innovative business will drive out traditional businesses results in increasing GDP and declining market cap of big companies and that will somewhat stabilize the Market cap to GDP ratio.

    ·   Money will not actually flow from stock market to bond market, but it will happen vice versa. On this point Michael Burry and Cathie Wood looks in the complete opposite directions and they often argue each other on it. The reasoning behind Wood’s statement is that she believes bond market would continue to perform poorly in the future and investors keep finding stock market attractive over the bond market. If we analyze the reasoning in Indian market context it is very much true by seeing FDs and other secured debt instruments interest rate etc.

·      Inflation is not a concern: she arguments that asset price inflation i.e if the stock market is gone up it is not going to stay in that manner always because of innovative companies like Uber, CoWork are coming into the picture. Innovative companies like these cut down the prices that are existing, so they cut down the inflation also. 

      After discussing both the approaches we can say that Mr. Burry is playing on Historical Data and Tools which indicate a crash is going to happen and Ms. Woods is betting on the future and the evolution of Disruptive companies. 

       What might slow down the rally?

     When the Indian bond market offers very attractive yield than its existing rate then the money would flow from stock market to bond market or in the worst-case scenario “Knee Jerk Reaction” takes place. Now these yield adjustments or tapering from the central bank will take place over the long period of time till than there is no point of panicking or stop investing resulting in sitting on pile of cash. If everybody thought that the correction will happen then the correction would have happened by today. 

    (  “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)

        Investments are always about alternatives if we pull back our money from stocks where are we going to invest it?

- FDs? It offers much lessor interest rate and if we consider inflation in that scenario, we are infact losing our money because inflation rate is higher than FD interest rate in real.

 - Real Estate? It is overvalued as well.

      Ultimately, we will have to invest our money in businesses atleast they are taking the advantage of the inflation. When the extra money is flushed into economy somehow businesses or banks get the money at the end which results to increase in their earnings and their share price goes up as well.

What can we do to protect our investment from the uncertainty in future?

1.       We can hedge our investment by buying other alternative like Crypto currency

2.       We can diversify our investment in different segments

3.       We can invest in companies that will grow with middle class India because many experts   see India becoming more prosperous in future.

4.       We can invest in mutual fund or invest on expert’s advice.

5.       Stay away from overvalued stocks.