Factors Indicating Markets Are Heating Up

When it comes to investing in equity markets or any equity-related instruments, it is expected to witness volatility. To simplify, the equity investments are subject to market fluctuations in terms of prices. While volatility is considered as a risk, investors should be interested in the possibilities of profiting from such swings happening in markets. However, it is possible to tackle the volatility either by pricing the market or timing the market. So, what is meant by pricing the market and timing the market?

Timing means the endeavour to anticipate the action of the market to buy and hold when future course is deemed to be upward and to sell or refrain from buying when the course is downward. On the other hand, pricing means the endeavour to buy stock when they are quoted below their fair value and sell them when they are quoted higher than the fair value.

We would advise one to focus on pricing the market rather than timing it. While it is difficult to time the markets to precision, in a broader sense it is possible to gauge if markets are peaking out or not. There are many factors that provide entry levels for investment, it is important to understand what the factors that provide an exit strategy are. There are certain factors that may provide indications or signals that markets are peaking out and help us in avoiding some mistakes like holding on despite over run in terms of valuations.

When we talk about the timing of the markets it means buying low and selling high. However, timing the markets is impossible and it only happens in stories. Nevertheless, there are factors which indicate that markets are peaking out and hence, one must get cautious while investing at such levels. It can be broadly segregated in following:

• Historically high levels of Benchmark Indices
• High price-to-earnings ratios
• Low dividend yields
• High speculation on margin
• Poor quality initial public offerings (IPOs) tapping the primary markets

Historically high index levels

Historically high index means when markets are breaking new all-time high levels almost everyday. We had seen historic high index levels in 2008, when the markets were scaling new highs almost every alternate day. While benchmark indices were making new highs, corporate earnings were not able to match up to the index pace. It is a known fact that, when indices move towards new highs, 75 per cent of the time, it is on account of price-to-earnings (P/E) expansion and not the earnings-per-share (EPS) growth. Historically, it is also seen that many of the investors invest a larger chunk of sum when markets are at historical highs. It is also called a fear of missing out (usually visible when markets are consistently new highs). As a result, there is a higher amount of liquidity that leads to overrun in terms of valuations. This leads to the second important factor, high P/E ratio or overrun in terms of valuations.

High price-to-earnings ratios

P/E ratio is not the only factor to value equity markets. It is one of the most important parameters to look at. Let us take an example for the same. In 2008, the Indian equity markets were scaling new highs but the earnings of India Inc. remained stagnant. This eventually resulted in a high P/E ratio during that period. As a result, when the markets had overrun the earnings, the markets declined to arrive at the right kind of valuations. Benchmark indices moved to new highs afterwards, however, it was then backed by the earnings growth.

For instance, when the market first touched the 21,000 level on January 9, 2008, the Sensex was trading at 28.57x. Similarly, on November 5, 2010, when the markets again touched the 21,000 mark, the P/E stood at 24.15x. This indicates that, when valuations are getting stretched it is time to be cautious. It is important to track the index EPS growth and P/E levels. To simplify, Sensex is currently trading at 35.36x of its trailing earnings. It is debatable that the markets move on expected future earnings growth and not the past record. However, we advise that, in uncertain times (like the way the world is facing Covid-19 pandemic) future earnings are not certain.

Following chart shows the impact of higher P/E on markets. In years like 2000, 2004 and 2008 when the P/E was higher, the benchmark Indices had witnessed some correction. While sometimes it was severe sometimes it was minor corrections.  The red line is Nifty 50 Index movement and the blue line is P/E.

It is true that the P/E at current levels is also at stretched levels, the current are extraordinary times and hence it is better to understand the future P/E and Earnings growth post the pandemic.

Low dividend yield

Investment in equities is made to earn capital gains. However, one cannot ignore dividend income. Dividend is one income which is not taxable (to certain extent) and hence, many investors look for higher dividend yielding stock. However, when the markets heat-up, the dividend yield ((dividend per share/current market price)*100) tends to be lower. Naturally, when the prices of scrip’s are up, the dividend yield will decline. And when the dividend is lower than the bond yields, it is a sign that markets are trading at higher levels as against the valuations they deserve.

Following chart categorically shows how at every peak the dividend yield of Nifty 50 companies has been very lower.

High speculation on margin

As mentioned earlier, market participants usually tend to invest more when indices are at historical high levels. Or we can say more participants want to join the party. Usually, trading volumes in the markets spurt up when the markets are on high. As a result, the trading volumes are high and investors (as they call themselves) trade higher on margin money. Worst is, many people start investing (or trading) in markets even by borrowing money. One must understand that leverage is a high risk factor. When one takes leveraged position, they only consider favourable outcomes in the market. However, similar leverage would result in significant losses if the outcome of the market is not in his favour. So, it is advisable that, whenever one sees high margin trading happening in the markets, it is time to get cautious. Remember, when we get into leveraged trades we only think about – profitable trades. But similar impact is applicable on downside as well. In similar leverage the losses would also occur if the call is wrong. And we are human; going wrong is also a possibility.

Usually, the derivatives markets witness such trading with higher volumes. But one should understand that derivative markets are hedging tools and are not meant for speculation. Currently a lot of steps are being taken to put curbs on the leveraged trading. Rather the recent circular suggests that the margin requirements are going to be slightly higher from June 2021 onwards.

Poor quality IPOs

The promoters who want to tap the primary markets try to take advantage of bull markets. So that they get better prices for the stakes they are selling in the markets. Hence, whenever the markets are peaking, there’s a flood of IPOs. Like they say, “The IPO is floated in favourable time, but time favourable for sellers and not the buyers.” The poor quality IPOs usually hit the primary market floor when the markets are at peak and try to get better valuation. Even Warren Buffet says “The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them. Too often, an IPO, not profits, was the primary goal of a company’s promoters. At bottom, the “business model” for these companies has been the old-fashioned chain letter, for which many fee-hungry investment bankers acted as eager postmen”.

The following table shows how at every peak the number of IPOs has increased as most of the promoters want to raise higher amount by diluting lower equity. Historically it is been seen that even the poorest of performing company manages to get investors interest (mostly retail) in bull phases. There are many examples where companies had a great IPO response and are not even trading now. Following table shows the number of new issues and amount raised through those.

Conclusion

It is not necessary that above five points are taken as a thumb rule. However the valuations, new issue supply and speculation on margin are factors one should always keep an eye on. Better to be cautious than being sorry. Always check for risk reward scenario and then only take exposure.