COVID-19: The Pin That Burst a Bubble

As of writing this article, COVID-19 has ravaged across the globe, affecting over 3 million people worldwide. The situation is bleak as the global economy has come to a standstill. The longest bull run in history is over and stock markets are crashing faster than ever before. Financial institutions and companies have pinned the blame on the pandemic for the mammoth loss in value and revenue.

The stock prices of these companies have taken a beating, some declining as much as 50%. However, upon taking a closer look, even after the bloodbath on D-Street, the market's barometer of performance (NIFTY50) is trading at a premium of 22 times its consolidated earnings! The big question remains, "Has the market bottomed yet?"  Many suggest that once we overcome this health crisis, we will see a V-shape recovery in economic activity and hence stock prices will go back to where they belong, setting new all-time highs.

I am of the opinion that the pandemic was just a pin to pop the bubble of an over-inflated stock market. The underlying problems run far deeper and due to the stock market's inefficiencies in factoring fundamental data while being fueled by speculation, stock prices had risen to a point from where a crash was inevitable.

My opinion is one based on a combination of economic factors and their influence on stock market charts which can be seen through technical analysis.

The Pre-COVID-19 Scenario

On the 20th of January, 2020 NIFTY50 opened at 12,430.50, marking the peak of the longest bull run in history which began on the 27th of October, 2008 at 2,524.90. I will first talk about the state of the economy leading up to the market crash by looking at the numbers that make up our GDP.

Corporate Investment and Growth

Coming into the second half of 2019, the Indian stock market was celebrating a record high almost every other week but the contribution of the underlying, i.e companies that make up the stock market, to the GDP was diminishing every quarter. 

The bottom line of most Income Statements has failed to grow/keep up with the GDP however if we look at other aspects of domestic expenditure in the form of capital investment, even those numbers have declined from 40.22% of GDP in 2010 to 31% of GDP in 2018.

It is quite clear that corporate performance has been declining over the last 6-years even though we have seen our 2nd largest growth cycle in terms of absolute growth of GDP.

Government Expenditure

Government expenditure is closely linked to the government's policies and looking at this purely from an economic sense, it is clear that during the second half of UPA-II, policies shifted from investment in infrastructure to providing welfare schemes like subsidies. The NDA followed in the same lines with a huge expansion in the subsidies provided to the lower and middle class like on LPG. Even fertilizer subsidies which flow to farmers with irrigated farmlands saw a great upward leap. 

Indian Central Government Total Expenditure to GDP

Clearly, with the fiscal deficit being reigned in, the money for these subsidies came from a reduction in capital expenditure.

Consumer Spending

Consumer spending has been the driver of the expansion in this decade. The relationship between consumer spending and government expenditure has been discussed in detail before over here but in a single line, the idea is that increased government expenditure gives impetus to consumer spending by boosting consumer confidence. 

Consumer spending has stayed mostly stable during the past decade showing signs of weakness in the last two years seen through the decreasing demand for goods. Consumer spending declined for the first time in four decades in 2017-18. As per a survey conducted by the National Statistical Office (NSO), the average monthly expenditure by an individual fell by 3.7% to Rs. 1,466 in 2017-2018 from Rs. 1,501 in 2011-2012 (adjusted for inflation).

Net Export

The final piece to the GDP puzzle is the net export and India has never fared well on that front. Coming to the end of the decade, the balance of trade has been declining and with a depreciating currency, it paints a glum picture.

Balance of Trade

Foreign direct investment in the country has remained stable over the past 10 years but like during every economic crisis, it tends to flee the country since it is generally in the form of saleable assets (VC/HF/PE). Its role in augmenting the economic output of the country is limited.

Role of Inflation

Inflation is a highly debated topic but I feel it is worth mentioning here because of the influence it has on consumer spending habits and corporate earnings. Inflation causes a rise in price levels but just because goods and services in a country cost more, it does not mean that the real GDP will increase. However, moderate inflation allows companies to charge more for their products and therefore reinvest a higher sum of money in growth activities. Consumers will tend to look for investment vehicles which allow them to beat inflation instead of leaving their money in a Savings account which will cause their money to depreciate in value.

Inflation Rate - India

A high inflation rate as seen in the last couple of years is detrimental for the economy because when goods and services reach exorbitant prices, the cost of raw materials for companies increases a lot and therefore need to charge much higher to make a return. In such an environment, consumers tend to spend lesser on discretionary items and choose to preserve cash. Investors looking to beat the high inflation rate will have to invest in instruments that offer a much higher return but also are a lot riskier. Hence, a high inflation environment which had been created made it harder for businesses and consumers to spend money and therefore influence the growth of the economy.

Coming to the Charts

The purpose of highlighting the key factors of GDP growth over the past decade was to bring into perspective how even during a period of tepid economic growth, the stock market has not reflected this. Throughout the bull-run, NIFTY50 has offered returns of 17% CAGR.

Now, using technical analysis I will highlight some important events over the past decade and their influence on the stock market. Post which I will focus on analysing the current scenario and what prices I expect NIFTY50 to be at in the near future.

NIFTY50 - Monthly Chart

The image above showcases the monthly candlestick chart for NIFTY50 between October 2008 (beginning of the bull-run) till the present day.

Each green/red candle indicates an increase/decrease in the price of the index over a period of 1 month. 

The vertical green/red lines drawn from top to bottom indicate an increase/decrease in monetary repo rate.

The yellow line is drawn from the left end of the chart (October 2008) and indicates the fair value of the index. It has acted as crucial support during the period of the bull-run and the index has bounced back from this level every time up until the crash. 

Support - A support line indicates a psychological price point where buyers tend to exist in large numbers. When prices reach this point, the high buying pressure causes the price of the stock/index to increase.

The section between A and B is the period between March 2015 and February 2016 where the index fell 20%. That year was a turbulent one due to multiple reasons like weak earnings, unfavourable budget, the Greek crisis, devaluation of the Chinese currency. The central bank slashed interest rates throughout this period from a decade high of 8% to 6.50% to stimulate growth. 

Point B acted as a support and a new leg for the index began. At point B, the P/E ratio of NIFTY50 was 19.53, a fair valuation for an emerging market. From this point on the valuations continued to deteriorate as prices increased but net profit for the underlying companies decreased.

NIFTY50 - Daily Chart

The image above showcases the daily candlestick chart for NIFTY50 between the peak of the bull-run (January 2020) till the present day.

Each green/red candle indicates an increase/decrease in the price of the index over a period of 1 day.

At the peak of the bull-run on 20th January 2020, the P/E ratio of NIFTY50 stood at 29.8, an extremely high valuation for a falling economy. The decline began and after falling 39.33%, prices began to rise again. The key price level I would like to highlight is the 9,970 level (indicated by the red line). It marks the 50% retracement level from the bottom and historically this level has acted as a strong resistance.

Resistance - A resistance line indicates a psychological price point where sellers tend to exist in large numbers. When prices reach this point, the high selling pressure causes the price of the stock/index to decrease.

NIFTY50 - Daily Chart (2008)

During the financial crisis, the 50% retracement line (red line) acted as a strong resistance. This phenomenon can be seen in crashes across the world in the early 2000s and 1987 and 1922.

The Bottom Line

This market crash proves to be a double-edged sword as the government needs to balance its stimulus programs for reviving the economy as well as ensuring citizens are safe and the disease is taken care of. Any step taken on one side is counterproductive for the other. Without an end in sight and economic data for March and April yet to surface, it is speculative to say that the worst is behind us.

The stock market right now is heavily focused on any COVID-19 related news. Governments across the world are pumping the markets and economy with steroid-like measures - large monetary infusions, unviable interest rates, LTRO operations, liquidity provisions, the extension of economic deadlines, printing currency etc. These measures are unsustainable and will have to stop eventually. 

When we near the end of the pandemic, I do expect a surge in stock prices due to positive sentiment. But, once that subsides and the market actually looks at the economic destruction the pandemic has left behind. Prices will begin to decline to its fair value and then below that due to the nature of markets.

During the financial crisis, the market crashed and prices declined by 60%! And that was just a financial crisis, governments were able to focus all their efforts on reviving the economy. Are we saying that during a financial AND health crisis, a 40% decline is the most we will see?

I expect the market to bottom in the next 18-20 months and the price level to decline to 6,500-6700 levels for NIFTY50.