The equity indexes have reclaimed, in the last two months, most of the losses from the pre-pandemic period. The rally has just happened close on the heels of a drastic fall, and therefore, it is only natural that the question of whether the rally is sustainable or not may come up from time to time. The market crash happened due to the spread of the pandemic and the lockdown which followed it. The lockdown happened in all the major countries, the US, Europe, China and India, leading to severe contractions in economic growth, unemployment, shutdown of factories and production facilities etc.
Given the intensity of the fall in such a short period, the recovery too has been happening at an unexpected speed. What has helped the markets and discerning investors is the fact that on two fundamental parameters of valuation the market looked cheaper to buy, that is based on price earnings and price to book. This generated some amount of interest in the markets. The intrinsic value of stocks seemed higher than the actual price at which the stocks were being quoted.
The markets almost always move on expectations, expectations of improvement in economic conditions, growth and employment picking up, and the resultant higher corporate profitability and earnings. There is also a high probability of a vaccine being available soon for the pandemic. The market is obviously trying to price in optimism in the hope of better economic conditions. The best thing to do would be to invest when there is economic contraction and low earnings, and book profits as earnings start peaking out.
Lower interest rates and ample liquidity has facilitated the optimism and recovery like no other factor has. Liquidity expansion, also known as quantitative easing, has put more liquidity into the system which has led to an expansion of P/E. Cheaper liquidity helps expansion in valuation as witnessed during the post Great Recession time beginning 2007-08. But it is a fact of experience that once liquidity expansion ceases, due to central banks modifying their policies over time, the markets may also give up some gains unless the earnings growth expectations have become all the more staring and founded on actual growth.
The initiatives from the government like the enhanced allocation of close to Rs.1.50 Lakh Crs to rural employment programs including MNREGA, and the registrations under these schemes swelling to the extent of the displacement of migrant labourers is going to help the rural economy. The fruition of these schemes gradually through their reach is likely to enhance rural demand. This will also give a fillip to the price level, and thereby production. The monsoon season has been normal so far and it is likely to provide the more fundamental buoyancy to the rural economy through the bounty of good crops. This will give a much-required push to the domestic markets.
While making fresh equity investments, we need to factor in the probability of higher volatility. The impact of such volatility can be moderated to a large extent by investing in actively managed funds. Actively managed funds are expected to achieve just that. A time-tested approach to investing in such times is investing in a phased manner, over a period of time, like in a systematic investment plan. This facilitates investments in the event of market corrections and also take advantage of volatility.
The markets have moved up on expectations and optimism and could trade lower if the actual growth numbers do not come up to the expectations. The likelihood of numbers falling short of expectations is high because the pandemic is still raging in the US and in many countries and the occurrence of a second wave also cannot be ruled out. This complicates the situation further resulting in further dent to the economies. Potential risks may emanate from several other sources, the rising friction between China and the US is one such factor. Yet another thing is the likely rise in inflation in the post-pandemic period. This may prompt central banks to consider reversing their policies. The risk is quite limited on this account as of now.
