The Old-New Investment Lessons from the Recent Stock Market Crash

It took the BSE Sensex, India’s premier stock market index, a period of nine months (from late April 2017 to late January 2018), to go from 30,000 points to higher than 36,000 points. This meant a return of more than 20% in a period of just nine months.

In an era when fixed deposits give a post-tax return of 5% per year, a return of 20% in less than a year, has to be fantastic. Of course, there are many listed stocks which have given more than 20 % returns, during the same period.

Between January 29 and February 6, 2018, the BSE Sensex has fallen by around 5.8% and wiped out one-third of the gain between April 2017 and January 2018. A week’s fall has wiped off one-third of the gain over a period of nine months.

When the stock market falls, a new set of investors learn, the same set of lessons all over again. What does this mean?

The price to earnings ratio of the BSE Sensex crossed 26 in late January 2018. This basically means that an investor was willing to pay Rs 26 for every one rupee of earning for the stocks that make up the Sensex.

Between April 2017 and January 2018, the price to earnings ratio of the Sensex had moved from 22.6 to 26.4. This meant that while the price of the stocks kept going up, the profit of the companies they represent, did not move at the same speed. Ultimately, the price of a stock is a reflection of the profit that a company is expected to make.

The price to earnings ratio of NSE Nifty touched 27 in late January 2018. The midcap stocks were going at a price to earnings ratio of 50. And the small caps had touched a price to earnings ratio of 120.

Such price to earnings ratios, or what the stock market likes to call valuation, were last seen in 2000 and 2008. With the benefit of hindsight, we now know that at both these points of time, the stock market was in a bubbly territory.

In fact, all the occasions when the price to earnings ratio of the stock market was greater than in the recent past, 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.

Nevertheless, the stock market experts told us that this time is different because there was no bubble in the United States of the kind we saw in 2000 or that the financial crisis that broke out in 2008, was a thing of the past. Hence, there was no real reason for the stock market to fall. (Of course, to these experts, the lack of earnings growth did not matter).

The trouble is that when the markets are in bubbly territory, there typically is no reason for them to fall, until some reason comes along. The first reason came in the form of the finance minister Arun Jaitley, introducing a long-term capital gains tax of 10% on stocks and equity mutual funds. This tax will have to be paid on capital gains of more than Rs 1 lakh, starting from April 1, 2018.

Investors took some time to digest this, and the stock market fell by 2.3%, a day after the budget. If this wasn’t enough, the yield on the 10-year treasury bond of the American government came back into the focus.

This yield jumped by around 40 basis points to 2.85%, in a month’s time. This yield sets the benchmark interest rates for a lot of other borrowing that takes place. In the aftermath of the financial crisis that broke out in September 2008, the central banks of the Western world, led by the Federal Reserve of the United States, printed a lot of money to drive down interest rates.

This was done in the hope of people borrowing and spending money and the economies recovering. That did not happen to the extent it was expected. What happened instead was that large financial institutions borrowed money at low rates and invested them in stock markets all across the world. This phenomenon came to be known as the dollar carry trade.

All this money flowing in drove up stock prices. The problem is that as the 10-year treasury bond yield approaches 3 %, dollar carry trade will become unviable in many cases. Given this, many carry trade investors are now selling out of stock markets, including that of India.

The larger point here is that nobody exactly knows when the stock market will reverse. The way the market has behaved over the last few days, has proved that all over again.

The sellers are not selling out because the valuations are too high (they were too high even a month or two back). They are selling out because of an entirely different reason all together; investors are selling out because they are seeing other investors selling out. The herd mentality that guides investors to buy stocks when everyone else is, also forces them to sell when everyone else is.

Also, the stock market, when it falls can fall very quickly. The last generation of stock market investors learnt this when the BSE Sensex fell by close to 60 % between January 9, 2008 and October 27, 2008.

Is it time for this generation of stock market investors to learn the same lesson all over again? On that your guess is as good as mine.

Stay tuned!

The column originally appeared on Firstpost on Feb 6, 2018.

Coming up: The $9 trillion problem of global finance

3D chrome Dollar symbolThat global finance has been in a mess since the start of the global financial crisis in September 2008, is old news now. But the fact that a bigger mess might be awaiting it, should still make for news.
A January 2015 research paper titled
Global dollar credit: links to US monetary policy and leverage authored by Robert N McCauley, Patrick McGuire and Vladyslav Sushko who belong to the Monetary and Economic Department at the Bank for International Settlements (BIS), has been doing the rounds in the recent past.
As per this paper : “Since the global financial crisis, banks and bond investors have increased the outstanding US dollar credit to non-bank borrowers outside the United States from $6 trillion to $9 trillion.” In 2000, the number had stood at $2 trillion.
What this clearly tells us is that over the years there has been a huge jump in the total amount of borrowing that has happened in dollars, outside the United States. Hence, more and more foreigners(to the United States) have been borrowing in dollars.
A similar trend has not be seen in case of other major currencies like the euro and the yen. In case of the euro the number stands at $2.5 trillion. For the yen, the number is at just $0.6 trillion. “Moreover, euro credit is quite concentrated in the euro area’s neighbours,” the BIS report points out. Hence, a major part of the world continues to borrow in dollars.
The question is which countries have borrowed all this money that has been lent? As the BIS report points out: “Dollar credit to Brazilian, Chinese and Indian borrowers has grown rapidly since the global financial crisis…Dollar borrowing has reached more than $300 billion in Brazil, $1.1 trillion in China, and $125 billion in India. The rapid growth of bonds relative to loans is more evident in Brazil and India than in China.”
This is happening primarily because domestic interest rates in these countries are on the higher side in comparison to the interest rates being charged on borrowing in dollars. Further, in the aftermath of the financial crisis, the Federal Reserve of the United States, initiated a huge money printing programme and at the same time decided to maintain the federal funds rate between 0-0.25%. This led to more and more borrowers deciding to borrow in US dollars.
“A low level of the federal funds rate…is associated with higher growth of dollar loans to borrowers outside the US…A 1 percentage point widening in a country’s policy rate relative to the federal funds rate is, on average, associated with 0.03% more dollar bank loans relative to GDP in the following quarter ,” the BIS paper points out. And that explains the rapid expansion of dollar loans.
The federal funds rate is the interest rate at which one bank lends funds maintained at the Federal Reserve to another bank on an overnight basis. It acts as a sort of a benchmark for the interest rates that banks charge on their short and medium term loans.
Interestingly, countries which are referred to as emerging market countries have borrowed close to $4.5 trillion of the total $9 trillion. “The emerging market share – mostly Asian – has doubled to $4.5 trillion since the Lehman crisis, including camouflaged lending through banks registered in London, Zurich or the Cayman Islands,” points out Ambrose Evans-Pritchard
in a recent piece in The Telegraph.
So what are the implications of this? First and foremost the world is now more closely connected to the monetary policy practised by the Federal Reserve of the United States. As the BIS paper points out: “Changes in the short-term policy rate are promptly reflected in the cost of $5 trillion in US dollar bank loans.” What this basically means is that if the Federal Reserve chooses to raise the federal funds rate any time in the future, the interest that needs to be paid on the dollar debt will also go up. And with the huge amount of money that has been borrowed, this could precipitate the next level of the crisis, if the borrowers are unable to pay up on the higher interest. One of the dangers that can arise is “if borrowers need to substitute domestic debt for dollar debt in adverse circumstances, then the exchange rate would come under pressure.”
There are other risks as well that need to be highlighted. There is a growing concern that companies in emerging markets have borrowed in dollars to essentially fund carry trades, where they are borrowing in dollars at low interest rates and then lending out that money at higher interest rates in their own country. Hence, nothing constructive is happening with the money that is being borrowed. It is simply being used for speculation.
Many of the companies borrowing in dollars are essentially borrowing for the first time in dollars. And this leads to the question whether the lenders have carried out an adequate amount of due diligence. Further, some of this borrowing may not have been captured in domestic debt statistics of countries. This means that countries may have actually borrowed more than their numbers suggest. Hence, when the time comes to repay this can put pressure on foreign exchange reserves. Lastly, with firms borrowing in dollars, the domestic policy-makers like central banks and finance ministries, may be misled “by the slower pace of domestic bank credit expansion”. This could mean lower interest rates when they should actually be raised. Lower interest rates can lead to more asset bubbles in financial markets.
What is not helping the cause is the fact that the dollar has appreciated rapidly against other major currencies. It has appreciated by around 25% since June 2014 against other major currencies. This means in order to repay the dollar loans or even to pay interest on it, the borrowers need a greater amount of local currency to buy dollars.
To conclude, it is worth repeating what I often say: before things get better, they might just get worse. Keep watching.

(Vivek Kaul is the author of Easy Money. He tweets @kaul_vivek)

The column originally appeared on Firstpost on Mar 25, 2015