Bracing Yourself for a Possible Near-Term Melt-Up


(kashif kidwai) #1

I have borrowed the title of this article from a recent commentary by Jeremy Grantham. Read it first here - https://www.gmo.com/docs/default-source/research-and-commentary/strategies/asset-allocation/viewpoints---bracing-yourself-for-a-possible-near-term-melt-up.pdf?sfvrsn=4

In this article, Mr. Grantham first starts by pointing out the elevated levels of US stock markets. Whatever parameters you use, there is no denying the fact that markets are exceptionally high at this stage and have been for some time now. In fact Jeremy Grantham is not the first investor to warn about the exceptionally high levels of the stock indexes. Many other equally distinguished investors have been sounding the alarm as well. Howard Marks also sounded the alarm about the elevated risk levels and gave his advice to be cautious going ahead in his quarterly memo – There they go again… again. Some other very distinguished investors like Seth Klarman, Paul Singer, John Hussman, Bill Gross etc. have been quite outspoken about the risks in todays economy including the policies of central bankers around the world, China, Trump, etc.

But does the high levels of the stock market suggests that we are in a bubble which is going to burst? In the article referred to above, Jeremy Grantham explains that – “Price alone seems to me now to be by no means a sufficient sign of an impending bubble break.” Stock market bubbles are characterized by exceptionally high prices alongside signs of excesses and euphoria among the market participants. Many experts including Howard Marks, Jeremy Granthan and Robert Shiller agree that although while the current prices are high but the current stock market rally lacks the psychological, touchy feely elements of euphoria. Hence, we are not yet in the bubble territory although there are early signs that the bubble is beginning to form. One of the most important indicator of the euphoria and the resulting formation of bubble apart from price is “acceleration of price.” This has been observed in each of the previous bubbles wherein there is a final acceleration of price which takes the index to levels of ~60% higher within an average time of 21 months. And we can see early signs of this acceleration of price and hence formation of the bubble.

Other than acceleration, there are two other historically reliable indicators of the formation of the bubble. These are: - Concentration and Outperformance of quality and low beta stocks. These are related – concentration refers to the obsession of the investors with a few stocks such as Nifty50 in the 1960s, and Cisco and Microsoft in 1999 and FANGs in the current period. The second factor is pretty much self-explanatory.

The current rally in stock markets in India has been going on for a long time now. As a result, the valuations have become stretched and most of the stocks of quality companies are trading at exceptionally high valuations. The retail investors have poured back into stocks after getting hurt and staying out of the markets after the 2008 crash. All this has made the value investors very nervous and rightfully so. But as we have seen overvaluation is not the only trigger for a crash. For a bubble to burst, it has to form first. And in India as well, the bubble has not fully formed yet because we have yet not seen the second most reliable indicator of the bubble – acceleration. The Sensex has gone up by ~28% during calendar year 2017. While it increased by 16% during the first half, the growth decelerated to 10% during the second half of the year.

The current rally started in December 2016 and has been going on more or less uninterrupted for the whole of last year. Just to get a flavor of where we can go from here. As we saw, historically the price has increased by an average of 60% over the last 21 months in the previous bubbles. We already had an increase of 28% during the last 12 months in Sensex. Which means that the price should increase by another 25% during the next 9 months. This will take the Sensex to 41,600 by September 2018. We can construct various scenarios but the bottom line is this – we should see a final acceleration starting soon for a bubble to form.

What are the strategies we can use in the final stages of the bull market? Let me suggest a few:

  1. Start reducing the positions gradually and building cash to be utilized for that long-awaited correction
  2. Remain fully invested in high quality companies where you have conviction. You know that there will be a correction but you will remain invested for the long term.
  3. Start building up positions in cyclical / momentum plays which will do disproportionately well in the current environment

All of these have their positives and negatives. If we follow strategy 1 - although we know there will be a correction and we have some idea of timing. But it might come much later than anticipated. What if the current rally continues for 2 more years? The cash will be drag on the portfolio while the market continues to soar.

If we follow strategy 2, and the correction comes sooner than anticipated. Even the high-quality companies will suffer impairments. The quantum of the impairment will depend on length and depth of the correction. But at least the impairment in high quality companies will be still less than more speculative investments.

Strategy 3, I will admit is more speculative and value investors might want to stick to a combination of 1 and 2. But the returns can be improved further by also including a few high-quality cyclical / momentum plays in the portfolio. But here timing will be important and hence I label this as more speculative. Let me give a few examples.
• Real Estate sector has been the beneficiary of a secular rally over the last year. I’m not sure if the rally has run its course.
• Valuepickr community is well aware of the metals cycle, especially copper which has been discussed in some detail in a separate thread. However, i don’t have any insights to add over there.
• Hotels sector has been bogged down over the past few years but the cycle is starting to turn. The companies in hotels sector have already rallied by 50% or so. Can it be the next real estate sector?

I think a combination of the three strategies should be chosen in the current environment depending on our comfort levels. Would request others to join and take the discussion forward. I’m sure people have different strategies for dealing with bull markets. Whats yours?


(AmitContrarian) #2

If you would have stayed in the 2002-08 bull market leaders like Reality and infrastructure etc you would have lost money or dacade in some of the stocks.
Stay away from Financials , NBFCS , Auto etc.

You will be fine.


(Anupam) #3

Nice logic build up. Interesting was the 60% growth in 21 months figure.

Can you share some data points as validation…if it’s readily available. That would be nice.

Also anyone conversant with Fibonacci retracement skill can possibly add value on acceleration, duration of bubble and timing estimate.


(jayjain79) #4

Pretty nice article to prepare one for any adverse impact on his sky rocketing returns until now.I would like to add someobservation i made from motilal oswals wealth creation study-Currently the market is trading at exceptionally high pe,if we look at the history,same was the case in 1999 and 2007.however one cannnt time the market,since you make the best of money in bull market.The preferable strategy is to stay invested with strong fundamental companies,ensuring they have not surpassed extreme pe valuation.


(s) #5

Global exuberance,High expectations from Indian companies, Consumer led growth all are indication of market to be positively biased. There are few overhang global and local political risk which the investor fraternity is willing to forego. The rise is for sure but the haul will be slow and long. Brace for intermediate sharp correction as Market is not a a one way street.


(kashif kidwai) #6

The data is from the commentary referred to by Jeremy Grantham. They have used the historical data from previous cases of stock market bubbles.


(Sameer Wakude) #8

Hi,

How about trying “Permanent portfolio”?
Permanent Portfolio (PP) theory is an asset allocation strategy wherein:

Equity: 25% (Prosperity Hedge)
Gold: 25% (Inflation Hedge)
Long Term Gilt: 25% (Deflation Hedge)
Cash: 25% (Recession Hedge).
Reallocate once a year.
I ran a quick back test last week, from 2006-20017, not a single year. Minimum returns were in 2015 (1.16%) and max (25.61%).
Agreed the returns are not huge, but downside is limited. This is for a completely risk averse customer.


(Sameer Wakude) #9

I would say irrespective of the market levels, one needs to have a prudent allocation strategy based on their risk appetite.
My personal preferred allocation:
30% Liquid (FD + Liquid Funds + Ultra short term funds + Arbitrage funds + Short Term Gilt funds)
50% Equity (Fundamentally strong stocks)
20% Momentum stocks.


(Sameer Wakude) #10

Last but not the least,
one can frame a strategy based on Nifty P/E.
e.g.
Nifty P/E Vs Equity Allocation
Above 26 20%
24-26 50%
20-24 70%
16-20 80%
< 16 90%