Are Markets Frothy?

What can we guess about the future?

In an earlier blog, we created and updated a model for long-term future returns based on the risk-free rates as well as changes in valuations over time. We also delved into the thoughts about markets that were frothy earlier here. In this blog, let us use the model to make guesses about the future and see if markets are frothy.

We first start with the original equation: ERP_10 = -0.34 * dBP + 6%. If we decompose this further, we say Return_10 = Risk_Free -0.34*dBP + 6% where Return_10 is the returns to Nifty500 over next 10 years.

Guess 1: Nifty500 returns will be much lower than history going forward.

Risk-free returns drive the Nifty500 returns along with valuation changes. If we assume no valuation changes, we can create the following table of expected market returns:

As the risk-free returns reduce, we must expect absolute returns to the stock market to keep dropping. The below graph shows the returns of Risk-free rates over time.

In the late nineties, the risk-free rates were around 9-10% and it was reasonable to expect a return of 15-16%. Over the past 15 years, the average returns were around 6-7% and hence the Nifty500 returns have averaged around 12-13%. Off late, post covid, the risk-free rates have dropped to 3-4%. This translates to a return of 9-10%. If interest rates continue to be hovering at these levels over the next decade, we must reduce our expectation of stock market returns to around 9-10%. Note that stocks will continue to be the best investment avenue with returns of up to 9-10% as fixed income instruments keep reducing their yields.

Guess 2: Market returns from Mid Oct 2021 over the next decade will be even more lackluster.

We start with the graph of B/P over time.

As can be seen, B/P has been this low last seen during the run-up to the fiscal crisis. At the peak of the fiscal crisis, the B/P bottom at 0.15 (P/B of 6.3) in Jan 2008. So, in that sense, there is no doubt that starting valuations are stretched today and are close to all-time high valuations. Another way to visualize this is a histogram and where we are today.

We are in the ninety-six percentiles of occurrences in terms of valuation peaks. So yes, we must admit that starting valuation is close to the worst. It is possible that these valuations will persist over time. But instead of making point estimates, we must consider a range of options and their probabilities. Knowing the history of the last 23 years making an ex-ante prediction about the future that valuations will not improve would be incorrect. There is a more than good chance that valuations will compress and due to that, we will see a reduction in returns. Assuming a reversion to mean to 0.37 B/P ratio (2.7 on P/B ratio), we can expect the next 10 years returns to be as

Returns_10 ~ 3.5% -(0.37-0.23) *0.34 + 6% = 4.74%

That is a dismally small number but that is what history suggests about the future.

Guess 3: Return to Momentum strategy will also be much lower.

The monthly updated momentum strategy has provided a long-run excess return of around 7% against the Nifty500’s total return (pre-costs). For example, in the prior decade, the nifty500 returns averaged around 12%, and expecting ~19% for momentum was a good starting estimate. Given the guess two, we must pare down our expectation on momentum strategy as well. We can expect an 11-12% return over the next decade. Compare that with this past year’s returns of over 100%+, this will be a somber reality check.

Guess 4: Quality factor and stocks will also provide meager returns

For the last ~8 years, the quality factor has lost its shine against the index. This is because they have now become a dominant force amongst the Nifty50 stocks.

If this relation continues, quality stocks that now dominate the Nifty50 will see a decent reduction of future returns. Think of the big names such as Infosys, TCS, HUL, Nestle, Pidilite, HDFC, HDFC Bank, etc. These are great companies that have had a decent run-up and if the prediction is that Nifty500 is going to have meager returns going forward, it will not be possible without these biggies underperforming and providing meager returns going forward.

Conclusion

In the absence of any valuation changes, given low-interest-rate environment today, we must expect lower returns going forward. If the interest rates increase, we may get an increase otherwise, we must accept lower returns going forward. Valuations of the broad indices today are high and close to all-time highs, and this should further temper expectations on future returns from hereon. I do believe that big quality names will disappoint in the future if the above prediction holds good.

All the above may sound like a siren signal to sell stocks and move to the comfort of risk-free assets. I disagree. I think markets’ valuations can be stretched forever. I think the way to proceed from here is to have an active trend following strategy going forward. I shall write about that in the next blog post.