Industry

How to spot a potential bubble

“It’s not supposed to be easy. Anyone who finds it easy is stupid” — Charlie Munger Having set the context for this article, let’s start with a simple definition of a ‘bubble.’

Bubbles occur when assets become artificially expensive, driven by a false belief known as a misconception.

There are identifiers that might help us spot potential, irrational exuberance in the market. Here are seven of them:

Entry of new investors

About 1.42 crore new demat accounts were added in FY21, which is about threefold more than that seen in FY20.

The average age of new investors is trending lower, and the mix is getting skewed towards tier 2 and 3 locations. This indicates that new investors with limited experience are entering the market. Most of them have experienced only a one-way upward rally in the last 15 months. In the short term, the market is like a pendulum — we need to watch the behaviour of the new investors during a downturn to understand the sustainability of retail participation.

Leverage play

Clients are willing to take on more leverage to benefit from the rally. (Leverage refers to the act of borrowing money to speculate in the market; this is generally funded by the broker or by an NBFC). Most of the broking houses’ margin-funding book has doubled in the last year.

Leverage is a double-edged sword. In good times, leverage magnifies the return and during a downturn, which is generally inevitable, it takes away a lot of capital earned when the market was rising.

Unless used wisely, leverage does more harm than good to investors, especially if they approach investments as speculators and not long-term investors.

High risk appetite

Raising money without difficulty is one of the biggest signs of market sentiment as investor risk appetite at this juncture is very high.

Investors are willing to allocate more capital than they would otherwise, towards asset classes which have done exceedingly well in recent times.

Record collection by new funds, grey market premium (GMP) and large IPO subscription (bids exceeding 100 times the quantum up for offer) are testimony to this sentiment.

Big-ticket IPOs

One more sign of a potential bubble is large IPOs starting to hit the market and getting oversubscribed. When IPOs of new, loss-making companies are subscribed with a lot of enthusiasm, most of the investors tend to sell their long-term wealth creator stocks to participate in new stock ideas which get all the attention at that point of time.

As investors, we need to remember the base rate of success while making investment decisions in new age start-ups. In high probability, few of these companies might become wealth creators in the future. That all the new-age companies are going to perform like Amazon or Netflix is a big assumption to make and only long-term evidence can support such a strong narrative.

Predictive power

Another sign of market exuberance is to check the degree of confidence among market participants on future prediction. Past projections on market-earning estimates can be very optimistic but reality turns out to be bleak for many reasons. For example, for the year 2020, NIFTY EPS estimate was ₹650 plus when it was initially projected during 2019. The actual EPS turned out to be ₹453.

We should allow companies we invest in to exceed our conservative expectations.

Small-cap trades

In the last few months, the rise in traded volume of small-cap stocks is much higher than for stocks with large capitalisation, more liquidity and a wider investor base. Trading or investing in thinly-traded stocks or those with lesser institutional coverage should be kept to a minimum. As and when the tide turns, companies with poor fundamentals might see permanent declines from the current price levels.

In April 2021, NIFTY Smallcap volume was 30-40% of NIFTY 100 volume and by the first week of July 2021, it had risen to 55%.

Sudden rise in valuations

In every market cycle, a few sectors or a few types of stocks get all the attention. Here is an example of a company that had a big tailwind due to COVID-19, which led to a sharp jump in its business. Profit almost doubled from FY20 to FY21 — a period when our economy suffered one of the worst contractions in our lifetimes. On top of this elevated earnings base, the stock is currently trading at 75 times reported earnings; it used to trade in the range of 20-25 trailing 12 months’ price-to-earnings ratio, as observed in the past.

As investors, our job is to not get too excited about the current earnings growth alone. We need to focus on sustainable growth in the medium term and avoid overpaying in order to improve our margin of safety.

As investors, we do not have the ability to predict the future but what we can do is to look for all the evidence around us dispassionately before taking decisions. Protecting the downside risk is one of our primary jobs in addition to generating sustainable long-term returns.

(The author is head of research and co-fund manager at ithought Financial Consulting)


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Printable version | Sep 28, 2021 2:09:16 AM | https://www.thehindu.com/business/Industry/how-to-spot-a-potential-bubble/article36038258.ece

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