28 Oct, 2022

September 2022 Quarter Update

“When I see a bubble, I rush in to buy it.” – George Soros

A ‘bubble’ in the context of investments and stock markets is when asset prices rise rapidly and then fall sharply – because price has deviated from underlying value. The metaphor underlying the term is that of a soap bubble that expands until it pops. Soros loves a bubble. Newton on the other hand not so much. Newton got caught in the South Sea bubble and could not get out until it was too later. It could be said that he was perhaps applying the incorrect framework to invest in stocks. Meb Faber thinks that if Newton had been applying a trend following strategy he would have got out at a 44% loss which doesn’t sound too bad against the 90% loss he reportedly suffered. [1]

(Source: Riding the South Sea Bubble, Temin and Voth)

Finance academics they say suffer from physics envy. Equations and laws in physics and other natural sciences are universal. In finance they are contextual and nuanced. They have to be applied with a lot of care and rigor.

Nobel Prize for Economics in 2013 (yes we know its not really a Nobel), was given to Eugene Fama and Robert Shiller. They both have absolutely contradictory views on the efficiency of stock markets. Fama thinks markets are strongly efficient and it is close to impossible to beat them consistently over the long run. Shiller, on the other hand believes that markets are not efficient as investment decisions are driven by emotion and not by rational calculations. The truth as usual lies somewhere in the middle. Another Nobel laureate, Vernon Smith, simulated stock market conditions in a controlled setting and observed how bubbles are formed as prices deviate from underlying value. These therefore are a feature and not a bug, in markets.

“A lot of financial debates are just people with different time horizons talking over each other” – Morgan Housel

GMO in their note “Entering The Superbubble’s Final Act” write “Ordinary bubbles are, to us, those that reach a 2 sigma deviation from trend. Superbubbles reach 2.5 sigma or greater. The true U.S. superbubbles – 2.5+ sigma events – are 1929, 2000, and 2021.” The graph below shows that US “was” in superbubble territory last year. And it has since then corrected to the mean valuation range. However no one is to say that it stops here. We know that markets tend to overshoot both on the upside as well as the downside.

The last time US was in “SuperBubble” was in 2000. In comparison the latest super bubble hasn’t lasted that long nor has it done the distance it did in 2000. We cant, however, make predictions about how exactly it is going to turn out this time. Only liars and soothsayers can.

Are Indian markets are overvalued?

Depends. The CAPE ratio which is a slow long term measure says India is in over-valued territory but this trip we didn’t go into Super Bubble zone. We at best went close to Bubble zone. We did enter super bubble zone in 2000. This time we were nowhere close to those levels. However, we havent yet corrected to our mean levels, whereas the US CAPE ratio has. We currently are located between +1 and +2 Standard Deviations. Is it strength or lag? Only time will tell.

If we look at the TTM P/E multiple for the Sensex we are in between average and +1SD valuation, which means in slightly overvalued zone. Therefore some amount of time and price correction from here should not be unexpected.

India is not decoupled from the rest of the world. We will face the music in the bad times, if we are to participate with the global economy in good times. Echoing Housel view, Barry Ritholtz writes, “Some market bottoms are a process, a blind groping of various market participants with different risk tolerances, financial goals, and time horizons.”

Structural Changes Ahead

Another emerging trend is capital expenditure in this decade will be driven by governments and not markets or central banks. Russel Napier, well known market strategist and historian believes we will see a boom in capital investment and a reindustrialisation of Western economies. His thesis is that there are structural changes underway in global economies which will be very unlike the last 40 years where we have seen a secular decline in interest rates. The current surge in inflation, globally, which he called two years ago, is not cyclical as per him. We are making a move from a market driven capital allocation model to a model where governments (not central banks) will drive capex, like we saw in 1939 to 1979.

United States is pushing capex via the Bipartisan Infrastructure Law, India is pushing via Production Linked Incentive Scheme (PLI) schemes. The pandemic and war have disrupted supply chains and are driving themes like “China+1”, “Europe+1”, nearshoring, friend shoring (set up manufacturing in friendly countries) etc.

One big issue that governments have is Debt to GDP has gone over historical levels. The only way for governments is to inflate their way out of this problem. Napier believes, inflation will settle in the 4-6% range for time to come, as that will be an acceptable level compared with what we are witnessing now.

All the factors above together mean that we will be in a very different economic and investment paradigm compared to what we have witnessed in the last forty odd years from 1980 to 2020.

Performance

The markets made a good comeback this quarter and recovered the losses made in the first quarter. Sector rotation is underway. It is expected. Banks and Financials are taking the leadership from IT and Metals. Energy remains strong but is not gaining much. Capital goods, FMCG and Auto are also showing strength.

We believe our framework and process of investing is aligned to capturing medium- and long-term trends. In sideways and choppy markets, like the one we are currently in, our aim to lose as little as possible. Our performance numbers bear testimony to this belief.

Wishing your family and you a very happy diwali and thank you for reading!

Stay safe and take care. Thank you for investing with us.

Anish Teli and QED Capital Team, October 2022

Disclaimer: Nothing in this blog should be construed as investment advice. This is purely for educational purposes only. Please consult an investment advisor before investing.

[1] Learning to love investment bubbles: What if Sir Isaac Newton had been a trend follower? – Meb Faber