Are Markets Sustainable In The Long Run?

The last three years have been fantastic for investors in Equity Markets as they have made exceptional returns. The broader market proxied by the Nifty 500 index has almost doubled in the last 3 years whereas the Nifty Midcap and Small cap Index has tripled in the last 4 years.

The natural question, therefore, in the minds of people is, whether these returns are sustainable or whether it will be wise to book profits and invest somewhere else. This concern manifests when people are reminded of the inherent volatility of the Equity markets and the massive drawdowns that we saw during uncertain times such as the 'Covid crash' in 2020 and the 'Global Financial Crisis' in 2008.

This concern can be tackled by looking at the kind of risks that we are exposed to when we look at the markets today. Any significant corrections in the markets shall become plausible when the broader investor population is fearful of the future growth prospects of the country. The potential risks that can upset the current rally shall have to be either at the industry level, domestic macro level risks or global risks like the ongoing trade wars, or the geo-political tensions in the Middle East etc.

At the country level, there are hardly any industry-level or macro-level risks that could become large enough to create that fear factor in the markets. There could be volatile periods in the coming few years, where some or the other risk shall keep showing on the horizon. But we don't see any sizeable risk on the horizon right now that has the potential to consume or affect the Indian economy for a prolonged time. This gives us confidence to assume that we are not staring at a significant bear market scenario anytime soon over the next 2-3 years.

Having said that, the international outlook is far from optimistic right now. The Israel-Iran tensions are at a flash point and a conflagration can have a significant impact on trade routes, oil and overall stability in the region. On a similar note, the US Economic trajectory is still quite uncertain with sticky inflation and a wavering Fed to conclude which way the US Economy is headed in the next few years.
The other part of the risk emanates from the valuations at which stocks are trading currently.

In the last 12 months, we all have been witness to one of the most spectacular rallies in recent times. This has elevated the valuations far above the long-term historical averages. Many stocks, especially the average quality ones, have run far ahead of what their fundamentals justify. It shall be safe to say in the present scenario that the unbridled run-up that we saw in the last year is more or less done with and going forward investors shall have to be cautious and selective about what they are buying, and more importantly at what price they are buying.

The long-term investing philosophy of Equities is more relevant today than ever. Investors have to look at Equities as long-term allocation, I mean at least 5 years. In the short term, it is very difficult to conclude with certainty about any risk and in the event that some unexpected risks show up on the horizon, the drawdowns in the markets can be sharp. However, when you are looking at a long-term investment, such short-term volatility does not have any major impact on the overall returns of the portfolio.

The next question that comes to mind then is, what shall be the drivers that can help generate sustainable double-digit returns in the period ahead? This is best answered by looking at the overall macro environment in India. In a conducive macro environment, a good business with high-quality management is able to take advantage of the environment and propel forward.

India has been one of the fastest-growing Economies in the world for many years now, and it is unlikely to change anytime soon. We are looking at a sustainable GDP growth of at least 7% p.a. in the coming years. There are multiple drivers of this growth like the major policy reforms including GST and PLI which helped in the formalization of the economy. GST brought a unified tax system replacing the previous multiple indirect tax system, streamlining the tax administration and improving the flow of goods and services across the country.

The government in turn has increased public expenditure on infrastructure improving the country's connectivity and thereby facilitating much smoother and faster transport of goods and services. The PLI schemes introduced by the government have boosted the manufacturing sector and created an ecosystem in many new areas improving job availability for semi-skilled and skilled workers. This can be evident with the manufacturing PMI hitting a 16-year high of 59.1 while the service PMI is at 61.2, indicating confidence among the enterprises.

On the private sector front, the corporate leverage for large, listed companies is at a 15-year low, the order books of several companies are at a multi-year high, and banks are seeing improving asset quality with GNPA and NNPA numbers at decade-low levels.

While the major economies in the world are suffering from elevated interest rates and soaring inflation leading to sluggish growth, RBI has done an impressive job in taming inflation within the target range. The achievement is noteworthy as it accomplished this without hampering the growth levels of the country. Keeping inflation in control is very crucial as moderate levels of inflation create wealth for the population as a whole and increase purchasing power.

All of this discussion points out to just one logical outcome - India is right now in a Virtuous Cycle of growth, where one development shall feed into another creating an environment where entrepreneurial spirits shall continue to soar, and consumers shall have more money to spend. In such an environment, being in Equities allows investors to reap the full benefit of this Virtuous Cycle and create substantial wealth. We should not get overly concerned with short volatility and cast doubts on the sustenance of the rally. As long as the Economy is powering forward, the Equity Markets shall keep pricing in the growth.

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