In an interview with ET Now, Aswath Damodaran, Professor, Stern School of Business, NYU, says India’s economy is fuelled by change right from demonetisation to the opening up of sectors to global competition to banking. The changes in India are going to impact the market.
I read your latest post on how you have characterised the recent bout of volatility. First we saw a big fall. Everyone said run to the hills and sky would fall and now after that, we have seen a strong reversal as US markets have made an exceptionally strong comeback? What do you make of all this?
You know how sometimes during a long flight, the pilot comes in and says there is going to be turbulence ahead, put your seatbelts on? We are in that phase of the flight where there is turbulence ahead. There is going to be ups and downs and though once in a while you may crash in the ocean, most of the time you are going to have a safe landing. That is the way you have to think about it. There is turbulence in markets, you have got to live with that. That is why you get a risk premium sometimes. We forget what the definition of risk is until you are in a period like this. This is why you should be demanding a premium when you invest in something risky.
There are three factors why markets always correct. There are panic attacks — which are short-term in nature. Risk adjustments — which could be linked to interest rates or outright blood bath or beginning of a bear market which could be linked to an event or a trigger. If you really have to characterise the current leg of volatility and market fall in these three brackets, how would you characterise it?
The three reasons are not mutually exclusive. Almost every selloff has elements of all three. The question is which is the dominant one? This particular selloff was triggered by a new story about inflation increasing in the US. That inflation increase caught markets by surprise. When inflation goes up, historically risk premiums also go up. So, the increase in inflation pushed the market into a higher risk premium and once you see sell offs, then panic sets in. So, all three factors were in place especially in that first week.
The panic part of the attack has gone away and so what you are seeing now is an attempt to get into some steady state. If there is going to be higher inflation, that is going to mean higher interest rates and higher interest rates will have to be adjusted foreign value. That is why I said that there is turbulence ahead. Markets are going to have to adjust to the fact that they have had 10-years of abnormally low interest rates. That period is coming to an end at least in the US. A healthy economy in the US will mean 3-3.5% may be even 4% T-bond rates. It will take markets a little while to adjust to that new reality. This is one of those selloffs where there was a panic component in the first week but that panic component even if it goes away does not mean stock prices are going to bounce back to where they were before the panic because it had some real issues that we have to deal with the markets.
Is the current problem in the world about inflation a good problem to have because frankly two years ago, we were discussing the whole problem of negative interest rates? Now markets are scared because growth is making a comeback. Do you think the fact that inflation is coming back it is not a bad problem but a good problem to have?
Inflation is back but inflation is 2%, 2% is not astronomically high inflation. It is actually inflation that is consistent with a healthy economy. When we talk about inflation, we have to realise that part of the reason of inflation is the fact that the US economy is finally delivering wage increases.
For a decade, we talked about how low level labour is not getting any kind of an increase, any benefit from globalisation. Now that they are getting the wage increase, of course it is going to show up as inflation. To me inflation is a sign of a healthier economy and that in a sense is something we all want. That is why when people say inflation is a bad thing, I say, be careful what you wish for because you could have Switzerland or Japan as your alternative and think of what has happened in Japan over the last 20 years with deflation! You have had an economy that is in shamble and that essentially cannot grow. Inflation is more a sign of health right now at least. At worst, it will get to be 5% or 6% but at 2% it is more a sign of health, not a sign of sickness.
What in your mind could be that tipping point for the 10-year treasury paper beyond which you would say markets genuinely need to worry? Is that 4%, 3.5% or is that anything beyond 5%?
Rates have been the driver. Rates effect only by affecting the economy. So rates going up slows the economy down then. By itself, higher interest rates cannot hurt you as a company because you are in a healthy economy and you are going to pass those rates on to your customers. So, by itself, higher rates do not mean that the they are starting to slow the economy down and you have to think about the consequences for earnings growth. We are not even close to that tipping point yet.
The entry price of any asset also is a guiding factor to what will happen to projected returns. Given that we are in a six-seven year old bull market in US equities, the average valuations or the valuations for S&P are trading way above their historic high. Do you think somewhere we could be going through this patch of consolidation where growth will come back but markets will not get very excited because they have already moved in anticipation of strong growth?
I know my strengths and I know my weaknesses and one of my biggest weaknesses is I am awful at timing the market. While listening to my gut or my instinct say hey this is now the right time to buy stocks, I have discovered historically that I am more likely to be wrong than right and to remember that because I am tempted like everybody else to decide when to enter and when to exit.
So, I am going to give the same advice that I give all my kids that do not try to time the market. It is a hopeless task you are going to end up over time paying for it. Instead enter the market if you have money to invest, exit the market if you need the cash, let the market take care of itself. This should also mean that you are not trying to find entry and exit points because that is going to slow you down. I know people who have been sitting on cash for 10 years waiting for the right entry point on stocks and that is the consequence of trying to time entry. If you wait for the right time, it might never come. You would have a lot of money to invest. Just go ahead and invest it.
I am a stock picker so here is what I am going to continue to do. I am going to value companies and we will find something to be cheap. I am going to buy that stock and not look whether the market is cheap or expensive because that is not my strength. However, if you are good at timings markets, by all means go out and decide when to enter and exit but make sure you are being honest with yourself.
For the longest time, you have been an advocatory of calculating equity risk premium and on your website and again on your blog, you have maintained this on a daily basis. What is your take on the current risk premium for stocks and is the current equity rate indicating that one should be buying US stocks or US equities?
They are pretty close to have. I computed them with the premium for March last night and it is 4.96%, roughly 5% in the US right now. The historical average for that number is about 4.5%. You are actually getting a higher premium than you have had historically. To me that is not a red flag. In contrast, in 1999, at the peak of the dotcom boom, the equity risk premium was 2% while the average then was about 5%. 2% is much lower than 5%. So, if you would have asked me at the end of 1999, am I worried? I would have said yes. Today the equity risk premium seems to be a reasonable number at least relative to history.
But do you think Indian stock market and US stock market cycles are different because for India the economic recovery has not kicked in and for US economy the economic recovery has kicked in? As percentage of total profit, the percentage of GDP in India is at a historic low but in the US, economy profit as percentage of GDP is reading a record high. Again, the important indicator which Buffett often uses is the market cap to GDP and on that account, India is cheap but US markets are expensive.
There is a global component to the market still. If we look at the first week of February, pretty much every market in the world was affected. During the crisis period, the correlation across markets tend to go up. When the crisis recedes, local factors kick in and India perhaps more than any other large emerging market, has a lot of local factors kicking in. You have got banking reforms. You have got an economy that is fuelled with change right from demonetisation to the opening up of sectors to global competition to banking. You are seeing changes in India that are going to effect that market. In a sense, this might be the start of an Indian decade, just like the last 20 years had been China’s. Maybe this is the start of something big. Of course, these things can very quickly change. Today’s optimist can become tomorrow’s pessimist but you are right, as so many local factors are driving the Indian market that the correlation is probably lower than it has been historically simply for those reasons.
What do you make of the flight of the Indian banking sector? PSU banks are in a strong disarray, there is a structural and a cultural problem and the way these banks are getting recapitalised again and again by Government of India, just reminds me of a school kid with bad habits who is actually getting rewarded rather than get punished for bad behaviour.
Yes the cleaning of the banks is going to be the major issue that India has to face in the near term because anybody who has any degree of familiarity with the Indian banking system knows how much of a big bank loan system was based on lending where banks did not do their due diligence but because the family group or a business person with a reputation came to them, they were willing to lend on credit and now many of those mistakes are going to be brought to the surface. It will be interesting to see how big a problem it is because I do not think we even know how big it is until we start digging. You have seen only the start of the process not the end of the process and the cleaning up is going to be painful and as with regular companies as you have separate good banks from bad banks and perhaps some of those bad banks will have to folded into good banks. But it is going to be painful. Cleaning up banking mess is never going to be without consequences. You are going to see that cleaning up have some consequences not just for the banks but some of these lenders are also going to be called to account for themselves by regulators. All that is going to create some pain for them as well.
Let us assume that the PSU banking system in India does not get fixed. Do you think that could have impact on the aggregate credit and liquidity in the system because the basic purpose of PSU banks is also to lend, also lend growth capital and risk capital to companies and to entrepreneurs? If PSU banks will have a weak balance sheet and if they would be careful in now lending, could that have impact on the aggregate lending cycle per se for India?
Absolutely and I am a fan of creating corporate bond markets and healthy markets because if your only source of loans is bank, any banking crisis is going to become an economic crisis. It is time that at least the larger Indian companies started looking at the corporate bond market as a primary way of raising debt for companies. It is a much healthier system because you do not have the kind of crony banking when you have a bond market and that I think will make companies and banks healthier.
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