## Retail Investors or Chickens Waiting to Get Slaughtered in the Stock Market?

Every year, for the last eight to ten days of the year, I try and take a reading holiday. In this time, I try and read a lot of crime fiction which I absolutely love, and non-fiction, which I would normally not read.

This year was no different. I took my regular reading holiday and ended up reading a fairly interesting set of books. All this set me thinking about the current state of the stock market in India. But before I get to that, let me describe what provided the cue for that.

One of the books I read was titled Police at the Station and They Don’t Look Friendly. This is an Irish crime fiction book written by Adrian McKinty. The lead character in this book is named Detective Sean Duffy, who somewhere in the book says: “I went out to the BMW and checked underneath it for bombs. No bombs but I’d always keep checking. As a student I’d listened to an aged Bertrand Russell’s thoughts on the fate of turkeys being fattened for Christmas, the turkeys subscribed to the philosophy of inductivist reasoning and didn’t see doomsday coming. I will.”

The book is set in the late 1980s, when the Irish Republican Army used to be a terror in Ireland. Hence, Inspector Duffy, was in the habit of checking for bombs, every time he drove his car. In the paragraph quoted above, Duffy also talks about the British mathematician and philosopher Bertrand Russell, turkeys and inductivist reasoning. What does he mean?

This is where things get interesting and need some elaboration. Another interesting book that I happened to read was Everything and More-A Compact History of Infinity by the American writer David Foster Wallace. The book is a fascinating history of the mathematical concept of infinity, which anyone without any background in Mathematics can also read and enjoy.

Among other things, Wallace in this book also discusses the principle of induction (the same as inductivist reasoning which Inspector Duffy talks about). As he writes: “The principle of induction states that if something x has happened in certain particular circumstances n times in the past, we are justified in believing that the same circumstances will produce x on the (n+1)th occasion.”

Wallace then goes on to say that the principle of induction is merely an abstraction from experience. He then goes on to give the example of Mr Chicken (you can replace it with Mr Turkey and come up with what Inspector Duffy was talking about). As Wallace writes: “There were four chickens in a wire coop of the garage, the brightest of whom was called Mr Chicken. Every morning, the farm’s hired man’s appearance in the coop area with a certain burlap sack caused Mr Chicken to get excited and start doing warmup-pecks at the ground, because he knew it was feeding time. It was always around the same time t every morning, and Mr Chicken had figured out, (man + sack) = food, and thus was confidently doing his warmup-pecks on that last Sunday morning when the hired man suddenly reached out and grabbed Mr Chicken and in one smooth motion wrung his neck and put him in the burlap sack and bore him off to the kitchen.”

So, what happened here? The chickens in the coop received food at a certain point of time every day. This led them to believe that the future will continue to be like the past and every day they will continue to receive food. Or to put it mathematically, just because something had happened n times, it will happen the (n+1)th time as well.

But what happened the (n+1)th time was that the chickens were killed to be cooked as food. As Wallace puts it: “The conclusion, abstract as it is, seems inescapable: what justifies our confidence in the Principle of Induction is that it has always worked so well in the past, at least up to now.”

This is a concept that Nassim Nicholas Taleb also explains his book Anti Fragile“A turkey is fed for a thousand days by a butcher; every day confirms to its staff of analysts that butchers love turkeys “with increased statistical confidence.” The butcher will keep feeding the turkey until a few days before thanksgiving. Then comes that day when it is really not a very good idea to be a turkey. So, with the butcher surprising it, the turkey will have a revision of belief-right when its confidence in the statement that the butcher loves turkeys is maximal … the key here is such a surprise will be a Black Swan event; but just for the turkey, not for the butcher.”

As Taleb further writes: “We can also see from the turkey story the mother of all harmful mistakes: mistaking absence of evidence (of harm) for evidence of absence, a mistake that tends to prevail in intellectual circles.”

So, I guess by now, dear reader, the link between chickens (or turkeys for that matter) and the principle of mathematical induction must be very clear. But what is the link with the stock market investors? The Indian stock market investors since November 2016 have been like chickens and turkeys, where they have been well-fed in the form of good returns. And this has led them to assume that the good returns will continue in the time to come. At least, this is the feeling that I get after having spoken at a few investor conferences lately, and yes, the data suggests this as well. The logic as always is: “This time is different”. But is it?

Let’s look at some data which clearly shows that the stock market is clearly in a bubbly territory now. Figure 1 plots the price to earnings ratio of the Nifty 50, which is a reasonably good representation of the overall stock market, from January 1999 onwards.

Figure 1, clearly tells us that the price to earnings ratio of the stocks that constitute the Nifty index are at an extremely high level. The highest price to earnings ratio in the current rally was on December 26, 2017, when it touched 26.97. This means that investors are ready to pay Rs 26.97 for every rupee of profit that the Nifty companies make.

Figure 1:

At the beginning of the year, the price to earnings ratio of Nifty was around 22. From there it has touched nearly 27. This basically means that while the price of the stocks has gone up, the net profit that these companies make, hasn’t been able to rise at the same pace. The average price to earnings ratio since January 1999 has been 19.1. This also suggests that we are clearly in bubbly territory now.

There are 35 other instances of the price to earnings ratio being higher than the 26.97. All these instances were either between January and March 2000, when the dotcom bubble and the Ketan Parekh stock market scam were at their peak, or between December 2007 and January 2008, when the stock market peaked, before the financial crisis which finally led to many Wall Street financial institutions going more or less bust, broke out.

The highest price to earnings ratio of the Nifty was at 28.47 on February 11, 2000. As is clear from Figure 1, after achieving these peaks, the stock market fell dramatically in the days to come. As of March 31, 2017, the market capitalisation of Nifty stocks made up 62.9 per cent of the free float market capitalisation of the stocks listed on the National Stock Exchange. The point being that it is a good representation of the overall

market.

Lest, I get accused of looking at only the best stocks in the market, it is important to state here that price to earnings ratio of other indices is also at very high levels. Take a look Table 1.

Table 1:

Name of the indexPrice to Earnings Ratio as on January 1, 2018
Nifty 10028.1
Nifty 20030.32
Nifty 50032.36

Source: Ace EquityThe price to earnings ratio of the indices in Table 1 is at a five-year high. Table 1 tells us very clearly that the price to earnings ratios of the other indices, which are made up of small as well as midcap stocks, have gone up at a much faster rate than the Nifty 50.

This isn’t surprising. Every bull run sees the small and midcap stock rallying much faster than the large cap stocks which constitute the Nifty 50. And given this the fall as and when it happens, always leads to greater losses.

Investors, especially retail investors, continue to bet big on the stock market. Let’s look at Figure 2, which basically plots the total amount of money coming into equity mutual funds (i.e. net investment, which basically means the total amount of new money invested in equity mutual funds during a month minus the total amount of money that is redeemed by investors from these funds).

Figure 2:

Figure 2 basically plots the total net investment in equity mutual funds since December 2012. As is clear from Figure 2, as the stock prices have gone from strength and strength and their price to earnings ratios have gone up, the net investment in equity mutual funds month on month has gone up. In November 2017, Rs 1,95,080 million of net investment was made in Indian equity mutual funds.

This is an excellent example of retail money coming into the stock market, after they have rallied considerably. Will the stock market fall from here? History suggests that the Nifty 50 price to earnings ratio has never crossed a level of 28.47, and we are very close to that level. Having said that I do need to state something that the economist John Maynard Keynes once said: “Markets can remain irrational longer than you can remain solvent”. So, timing the market remains a tricky business.

Also, it is worth remembering here, that while the fund managers would like you to believe that this time it is different, it never really is. And when markets crash after such highs, they do so very quickly.

Let’s take a look at what happened in 2008. Take a look at Figure 3, which basically plots the closing level of Nifty 50, between November 2007 and December 2008.

Figure 3:

On January 8, 2008, the Nifty 50 reached a level of 6,287.85 points. More than 9 months later on October 27, 2008, it had fallen by nearly 60 per cent to a level of 2,524.2 points. Given that the stock market investors have a very short memory, Figure 3 is a very important chart. This happened just ten years back.

Of course, the retail investors who come in at the peak, get hurt the most, during such falls. What all this suggests very clearly is that the retail investors in the stock market are essentially chickens who are currently being fattened with good food in the form of returns. They are also assuming that this will continue. But what history tells us very clearly is that they are waiting to be slaughtered. And given that they will be caught unawares as and when the stock market falls, the bloodbath that follows will be ‘as usual’ extremely deadly.

Regards,

Vivek Kaul

This originally appeared in the Vivek Kaul Letter dated January 4, 2018. It was also published on Equitymaster on January 9, 2018.

## GDP Data Brings Us Back to the Basic Question: Where Are the Jobs?

Late last week, the central statistics office of the government of India declared its forecasts for the gross domestic product (GDP) growth for 2017-2018. The GDP is a measure of economic size and the GDP growth is a measure of economic growth.

The GDP growth for 2017-2018 is expected to be at 6.5 per cent. It is the slowest economic growth that the country will see after Narendra Modi took over as the prime minister. Take a look at Figure 1, which plots GDP growth.

Figure 1:

This slowdown is a clear impact of the negative impacts of demonetisation continuing into 2017-2018, which was followed by the terribly botched up implementation of the Goods and Services Tax (GST).

Take a look at Figure 2, which basically plots the growth of various sectors.

Figure 2:

Figure 2 tells us that agriculture and industry in 2017-2018, will slow down considerably in comparison to 2016-2017. Within industry, manufacturing will slow down considerably as well. The growth of the services sector continues to remain robust. Within the services sector, the public administration, defence and other services, which is basically a representation for the government, grew the fastest at 9.4 per cent (though it slowed down in comparison to last year).

What this basically means is that a fast growth in government expenditure in 2016-2017 and 2017-2018, pushed up economic growth, otherwise the economic growth would have been lower than what it finally turned out to be.

Now let’s take a look at investment to GDP ratio in Figure 3.

Figure 3:

For the year 2017-2018, the investment to GDP ratio is expected to be at around 29 per cent of the GDP. This ratio has been falling since 2011-2012 and there have been no signs of improvement since then. I have taken data from 2011-2012 onwards because the new GDP series data being used since January 2015, has a back series starting from 2011-2012 only.

In fact, the data from Centre for Monitoring Indian Economy suggests that new projects announcement in the period of three months ending December 2017, came in at a 13-year low. Take a look at Figure 4.

Figure 4:

The new investment projects announced during the period of three months up to December 2017, were the lowest since the period of three months ending June 2004. This is a clear indication of the fact that the industry is not betting much on India’s economic future because if they were they would be expanding at a much faster rate and announcing more investment projects than they currently are. The industrialists may say good things about India in the public domain and in the media, but they are clearly not betting much of their money on the country.

Unless, investment picks up, jobs can’t be created. And without jobs the one million youth entering the workforce every month or India’s so called demographic dividend, is likely to turn into a demographic disaster. Indeed, that is a very worrying point.

To conclude, the GDP data for 2017-2018, brings us back to that basic question: Where are the jobs?

The column originally appeared on Equitymaster on January 8, 2018.

## It’s Surprising That More People Aren’t’ Moving to Urban India

Filmstar and member of parliament, Hema Malini, blamed the recent Kamala Mills fire tragedy, on India’s population and migrants. She was quoted in a Zee News report as saying: “The population is so high. When Mumbai ends, another city should begin. But the city keeps extending. Uncontrollable… The administration has allowed every migrant to live in the city. However, looking at the wide population in the city, the authorities should have brought in some restrictions here to control the population.”

Of course, migration and population, had nothing to do with the Kamala Mills fire. It had everything to do with the collapse of governance that Mumbai (or for that matter most Indian cities) has seen over the years.

Having said that migration is a huge issue that many Indian cities are facing. In fact, as a recent discussion paper titled Changing Structure of Rural Economy of India Implications for Employment and Growth, authored by Ramesh Chand, SK Srivastava and Jaspal Singh, and published by the NITI Aayog, points out: “As per the 2011 Census, 68.8 per cent of country‟s population and 72.4 per cent of workforce resided in rural areas. However, steady transition to urbanization over the years is leading to the decline in the rural share in population, workforce and GDP of the country. Between 2001 and 2011, India‟s urban population increased by 31.8 per cent as compared to 12.18 per cent increase in the rural population. Over fifty per cent of the increase in urban population during this period was attributed to the rural-urban migration and re-classification of rural settlements into urban.”

The question is why is this happening. The answer is fairly straightforward. Agriculture, as a profession, is not as remunerative as it used to be. The average size of the land farmed by an Indian farmer has fallen over the decades and in 2010-2011, the last time the agriculture census was carried out, stood at 1.16 hectares. In 1970-1971 it had stood at 2.82 hectares. This has happened as land has been divided across generations. This fall in farm size has made farming in many parts of the country, an unviable activity, leading to the size of agriculture as a part of the economy becoming smaller and smaller, without a similar fall in the number of people who continue to be dependent on it.

In fact, the situation could have only got worse since 2010-2011, as farm sizes would have shrunk further. Further, there are states like Kerala and Bihar, where the farm sizes are smaller than the average 1.16 hectares across India.

The NITI Aayog discussion paper points out that in 2011-2012, agriculture contributed 39.2 per cent of the rural economic output, while employing 64.1 per cent of the rural workforce. In 2004-2005, agriculture had contributed 38.9 per cent of rural economic output, while employing 72.6 per cent of the rural workforce.

What this basically means is that between 2004 and 2012, many rural workers essentially moved away from agriculture to other areas. Many would have migrated to cities for better opportunities as well.

What it also shows is that way too many people continue to remain dependent on agriculture. The sector has what economists refer to as huge disguised unemployment. If we look at the national level, agriculture contributes around 12 per cent of the gross domestic product (a measure of economic output), while employing 47 per cent of the workforce.

This clearly means that those working in agriculture are worse off than those not working in agriculture. In fact, the NITI Aayog discussion paper points out that the average urban worker made around 8.3 times the money an average agricultural worker does. The average urban worker makes 3.7 times the money an average cultivator does.
Given this, huge difference in income, it is not surprising that people want to migrate from villages to cities. Another data point that adds to this trend is the fact that only around half of the rural workforce looking for a job all through the year, is able to find one. In urban India, this is more than 80 per cent.

Given this, many people need to be moved from agriculture into other activities. The NITI Aayog discussion paper points out: “To match employment share with output share of agriculture another 84 million agricultural workers are required to quit agriculture and join more productive non-farm sectors. This amounts to about 70 per cent increase in the non-farm jobs in rural areas.”

What all these factors come together to tell us is that it is surprising that more people not moving to urban areas from rural areas, given the huge difference of income between rural and urban workers and the fact that there is a huge disguised unemployment in agriculture. Given the limitation of data (with the Census only being carried out once every 10 years), we will come to know the real situation only once the next census is carried out in 2021. But seeing how things are currently, it is safe to say that more people will move from rural to urban areas, than was the case in the past.

The column originally appeared in Daily News and Analysis on January 7, 2018.

## Electoral Bonds Do Not Address Key Issue of Lack of Transparency in Political Funding

In the budget speech, the finance minister Arun Jaitely made in February 2017, he said: “Even 70 years after Independence, the country has not been able to evolve a transparent method of funding political parties which is vital to the system of free and fair elections.

He further added: “An amendment is being proposed to the Reserve Bank of India Act to enable the issuance of electoral bonds in accordance with a scheme that the Government of India would frame in this regard. Under this scheme, a donor could purchase bonds from authorised banks against cheque and digital payments only. They shall be redeemable only in the designated account of a registered political party. These bonds will be redeemable within the prescribed time limit from issuance of bond.”

If one were to summarise the above two paragraphs what Jaitley basically said was that the government of India proposed to introduce electoral bonds to make transparent the method of funding political parties in India.

Eleven months later on January 2, 2018, the Narendra Modi government notified “the Scheme of Electoral Bonds to cleanse the system of political funding in the country.” The press release accompanying the decision listed out the various features of these bonds. They are:

1) Electoral bonds would be issued/purchased for any value, in multiples of Rs 1,000, Rs 10,000, Rs 1 lakh, Rs 10 lakh and Rs 1 crore, from specified branches of the State Bank of India (SBI).

2) The electoral bond would be a bearer instrument in the nature of a promissory note and an interest free banking instrument. A citizen of India or a body incorporated in India will be eligible to purchase the bond.

3) The purchaser would be allowed to buy electoral bonds only on due fulfilment of all the extant KYC norms and by making payment from a bank account.

4) It will not carry the name of payee.

5) Once these bonds are bought they will have a life of only 15 days. During this period, the bonds need to be donated to a political party registered under section 29A of the Representation of the Peoples Act, 1951 (43 of 1951) and which secured not less than one per cent of the votes polled in the last general election to the House of the People or a Legislative Assembly.

6) Once a political party receives these bonds, they can encash it only through a designated bank account with the authorised bank.

7) The electoral bonds shall be available for purchase for a period of 10 days each in the months of January, April, July and October, as may be specified by the central government. An additional period of 30 days shall be specified by the central government in the year of the general election to the House of People.

So far so good. There are a number of points that crop up here. Let’s discuss them one by one:

1) The finance minister Jaitley in his budget speech last year had talked about electoral bonds introducing transparency into political funding. These bonds will not have the name of the person buying the bond and donating it to a political party. The question is how do anonymity and transparency, not exactly synonyms, go together? This is something that Jaitley needs to explain.

2) The electoral bonds continue with the fundamental problem at the heart of political funding—the opacity to the electorate. With the KYC in place, the government will know who is donating money to which political party, but you and I, the citizens of this country, who elect the government, won’t. This basically means that crony capitalists who have been donating money to political parties for decades will continue to have a free run. The electoral bonds do nothing to break the unholy nexus between businessmen and politicians.

3) For these bonds to serve any purpose, they should have the name of the person buying the bond. And these names should be available in public domain, with the citizens of the country clearly knowing where are the political parties getting their funding from.

4) Supporters of the bonds have talked about the fact that anonymity is necessary or otherwise the government can crack down on those donating money to opposition parties. This is a very spurious argument. With the KYC in place, the State Bank of India will immediately know who is donating money to which political party. And you don’t need to be a rocket scientist to conclude that this information will flow from the bank to the ministry of finance. Hence, we will be in a situation where the government knows exactly who is donating money to which political party, but the opposition parties don’t. If the government of the day can know who is funding which political party, so should the citizens.

Now what stops the government (and by that, I mean any government and not just the current one) from going after the citizens or incorporated bodies for that matter, donating money to opposition parties. The logic of anonymity clearly does not work.

The structure of the electoral bonds seems to have been designed to choke the funding of opposition parties, more than anything else. Also, it is safe to say, given these reasons, cash donations will continue to be favoured by crony capitalists close to opposition parties.

5) There is one more point that needs to be made regarding political donations as a whole and not just the recently notified electoral bonds. Earlier the companies were allowed to donate only up to 7.5 per cent of their average net profit over the last three years, to political parties. They also had to declare the names of political parties they had made donations to. This was amended in March 2017. The companies can now donate any amount of money to any political party, without having to declare the name of the party.

To conclude, electoral bonds do not achieve the main purpose that they were supposed to achieve i.e. the transparency of political funding. All they do in their current form is to ensure that the ruling political party continues to consolidate its position, at the cost of the citizens of this country. Of course, given the marketing machinery they have in place, they will spin it differently. Given this, the WhatsApp wars on this issue have already begun.

The column was originally published in Equitymaster on January 5, 2018.