It's beyond COVID-19

The Indian benchmark indices have corrected by more than 35 percent in 2020. The correction has been fast and furious. The market capitalization of NSE has eroded by a massive Rs 51 lakh crore in less than 3 months. This is about 25 percent of FY20 nominal GDP. The scale of wealth destruction is unprecedented.

Given the fact that real estate as a asset class has not given any meaningful return in past 8 years, and the return from corporate debt has also been minimal in past couple of years, due to multiple defaults, the impact of this wealth destruction is feeling substantially more pronounced. The experts are fiercely debating whether this fall in asset prices is a disaster or an opportunity.

Many believe that this shutdown of socio-economic activity due to spread of coronavirus (COVID-19) is a temporary phenomenon. It is the panic selling that is causing irrational fall in asset prices, and it is a good opportunity for the investors to accumulate good quality financial assets at bargain prices.

I would not go into this opportunity vs threat debate. I just want to highlight that mistaking this correction in prices purely due to disruption caused by COVID-19 would be a grave mistake.

In my view, the following couplet of Mirza Ghalib aptly describes the present market conditions:

"था ज़िंदगी में मर्ग का खटका लगा हुआ, उड़ने से पेश्तर भी मेरा रंग ज़र्द था|"

(When I lived I was always feared Death. Because of this fear, my color was always pale. Death has changed nothing)

There were many omens conspicuously present since past 5-6 years arguing for a meaningful de-rating of Indian equities in general. A large part of the market did take cognizance of these omens and corrected materially.

However a small part of the market contemptuously ignored these omens and kept trading at astronomical valuations. This segment like a pied piper led the benchmark indices higher and mesmerized a multitude of small investors into investing in these equities at bloated valuations. Unfortunately, the regulators, the government and self regulatory organizations chose to follow the trend and actively encouraged investors to keep regularly investing in markets.

The long term growth trend in India did never recover after the global financial crisis. Its been consistently declining since then. Except for a brief recovery period during FY13-FY16, the growth trend has remained down. Given that the domestic savings and investment rates have declined materially in past 5years, most agencies have even downgraded the potential growth rate of Indian economy from ~8 percent to ~6 percent.

The corporate earnings growth has been anemic for past one decade. In past 6 years, the Nifty earnings have growth at less than 5 percent CAGR. The visibility of earnings growth for next year was diminishing even without COVID-19 outbreak. The disruption has only worsened the outlook.

Moreover, the return on equity (RoE) for Indian businesses has been consistently declining over past decade. As per a recent research report by Motilal Oswal Securities, the RoE of Indian equities has declined from 18.1 percent in 2010 to 9.5 percent in 2019. As per the report, the present RoE of BSE500 companies is at 16 year low.

 

The global investors have recognized the trend quite early and have been selling Indian financial assets since 2015. Since 2015, FPIs have net sold over Rs 1.1 lakh crore worth of debt and equities in the secondary markets; though they have been net buyer of Rs 1.9 lakh crore if we consider both secondary and primary markets (Equity+Debt).

Multiple instances of willful defaults, frauds and regulators' apathy to investors have caused huge losses to the unsuspecting investors. The credit rating agencies and auditors have repeatedly failed in performing due diligence in performance of their duties. The mutual fund managements and fund managers have miserably failed in performance of their fiduciary duties by (a) breaching prudent exposure limits to single company, group, sector etc.; (b) subscribing to suspect quality debt; (c) failing in timely realization of collateral; and (d) failing in disclosing the true nature of the risk in various fund portfolios. Massive losses to the investors due to write down in debt securities of IL&FS, Essel Group, Vodafone, Yes Bank, etc is one major reason for investors' mistrust and disenchantment from financial markets.

The unusual weather in past 8-10 weeks has impacted the Rabi crop at many places in north India. This shall definitely impact the overall rural income; something the market was relying upon for economic recovery.

In short, multiple issues have been bothering Indian market for past few years. COVID-19 may have just triggered the fall; but it would be a grave mistake to believe that COVID-19 is the cause of this destruction in asset prices. This belief could especially be fatal for the smaller investors who may be considering buying equities with an idea of sharp bounce once the virus spread is contained and socio-economic activities return to pre January levels.

In my view, the derating of Indian equities may be structural and the valuations for top stocks that had led the rally in past two years may not reach the 2019 levels in next three of years at least.