Surging Bull, Hidden Bear.

     On Wall Street, there’s a saying that goes a little something like this. ‘This time, it’s different.’ And quite frankly, this time, things are indeed different. A bull market that has run for well over a decade, while shrugging off anything that may even seem like an obstacle. An American President who once ranted about the market being in bubble territory during his election campaign, now claiming credit for America’s booming economy and even stating that the same surging markets would crash if he was impeached. The same American President engaging in a trade war with and taking on the biggest holder of his country’s debt. The same American President first threatening a nuclear war against and then palling up with the Hermit Kingdom’s Kim. And the other Kim’s husband pushing back his 2020 Presidential bid to 2024 and then claiming that he’s distancing himself from politics and completely focusing on ‘being creative’. It may be 2018 but nothing makes sense anymore. 

     On the markets front, nothing seems to be able to stop the decade-long bull run. The PIIGS, China, Russia, Venezuela, Iran, North Korea, trade wars, oil and interest rates all tried but failed. Over the past eight years or so, most global indices have had a unidirectional upward rally. Despite short bouts of volatility and 5-10% corrections, the markets always seem to recover, scale new highs and have the last laugh. While volatility may have risen in recent months, it still remains below levels seen in the first half of the decade.

     The US economy still dictates the fortunes of markets around the world and while it may be said that 2017 and early 2018 were its best years, Uncle Sam’s economy is apparently still showing signs of further expansion, albeit at a slower pace. The Federal Reserve is shrinking its balance sheet by undertaking a series of rate hikes, with at least 2, if not 3 more potentially to follow in 2019, all intended to keep the US economy growing at a brisk pace.

     Simply put, everything about the global economy at present seems to indicate that optimism and euphoria are indeed the ruling sentiments. And of course, if you were to go by the trends that dominated September's New York Fashion Week, coupled with where the Hemline Index seems to be poised currently, the economy does indeed seem to be riding high and in really glamorous shape. Both literally and figuratively.

     But is there a catch? Well, there always is. The higher the climb, the steeper the fall. It’s usually at the very top of the market that sanity does seem to betray mankind. Be it astronomical real estate prices in east Asia, start-ups with zero revenue but billion dollar valuations in America or junk debt and housing loans packaged as securities which sold like hot cakes, it’s usually when the markets are climbing a precariously high summit that logic and fundamentals take a back seat. And this time around, it’s happening again. 

     Slowly but surely, more and more apparitions beyond the realm of logic and common sense seem to be making their presence felt. Investment funds of over $100bn focused on backing start-ups, the valuations of which are already shooting through the roof. Start-up valuations tripling in the space of twelve months despite widening losses and cash burn rates. Deal multiples at an all-time high and heading higher. ‘Maverick’ CEOs tweeting about taking their companies private, with no certainty on their sources of funding. Outrageously priced IPOs that end up sailing through albeit a weak debut. Gold prices showing nary a sign of strength.

     Intriguingly, the very asset that happens to be the safest haven of them all in a storm is the same asset that everyone’s bearish on. Gold is currently trading at levels seen before the Eurozone crisis rattled the markets and the commodity has lost investor favour, even as equities continue to be the asset class du jour.

     If you look back at 2007 to examine the signs of the impending crash in 2008 to identify the warning signs, a major red flag was seen than and worryingly, the same factor does seem to be the 800 pound gorilla in the room now. Buybacks have amounted to over a trillion dollars this year, with companies sitting on record levels of cash. In fact, over the past 3 years, stock prices have largely moved northward by companies buying back their own shares to a far greater degree than growing their earnings. Trump’s tax cuts and the repatriation of earnings stashed overseas have resulted in companies holding large volumes of cash on their books. And that cash is increasingly being deployed to buy back shares, in an attempt to return shareholder wealth but all it seems to be doing is inflating the bubble further. Cash is also being used fuel acquisitions at elevated deal multiples, which have risen from levels of around 9 times on the EBITDA front to the current levels of around 14 times. Even in India, consumer goods companies which trade at 40-60 times earnings have moved up from their 30-50 times range, largely driven by their multiples rerating and less because of their earnings growing. Another worrying factor is that the number of company insiders selling their shares is at an all-time high, a possible indicator that valuations are at levels that they shouldn’t be at and that there could be trouble ahead on the corporate front, which would go on to trigger a domino effect.

      As far as M&A goes, 2018 has indeed been a blowout year with deal numbers and valuations surging and most worryingly, deal premiums hitting record highs, all backed by a seemingly resilient stock market. The biggest of names seem to be more than willing to pay exorbitant premiums to buy their peers and emerge the victor in bidding wars. It goes without saying that the M&A cycle is indeed riding a major wave.

      But is everything in such pristine condition that there are no signs of the next downturn? Well, to put it simply, the cracks have already started to appear. If you believe in history repeating itself, the US economy has always been at its strongest in the days before the advent of a downturn and right now, it seems to be in that very state. Record levels of growth, falling unemployment and high levels of consumer confidence seem to be making the headlines. But all those parameters have already started dipping from their summits seen in late 2017 and early 2018 and sliding lower with each passing quarter. The Federal Reserve’s fast and furious rate hikes to control the pace of economic expansion in the USA might just deal a blow that the economy may not be able to withstand. If the US economic growth falters, the Fed’s rate hikes, intended to nudge the current expansion forward and onward, could turn out to be the strangling factor. The inversion of the US treasury yield curve has already occurred and historically, the event has always preceded a dive in the US economy. Warning signs, however, never flash in isolation.

     The automobile sector, traditionally an excellent indicator of where the economy’s health stands, seems to be on the slide. Profit warnings by several major automakers, falling sales numbers and global uncertainty as to where the industry is destined to go with the trifecta of electric vehicles, automation and shared mobility setting in are already sending the auto majors driving for the hills. Another sector that could serve as an indicator of economic health would be retail. Of course, the growth of e-commerce is a major factor but store closures and bankruptcies in the retail sector are on the rise. Additionally, corporate fraud generally tends to hit a peak at the very top of the market as well, just before a slowdown starts.

     When was the last time the global automobile industry saw a similar trend of slowing sales and looming bankruptcies? When was the last time we saw several companies file for bankruptcy and corporate fraud cases implode at the top of the market? The year then was 2007 and twelve months later, financial Armageddon began.

      If these signs are indeed omens for things to come, where does India stand in all this? Well, crisis after crisis has come and gone in the avatars of high oil prices, FIIs selling, NPA crises, corporate governance lapses, uncertainty on election outcomes and the IL&FS triggered NBFC saga. Yet, the market seems poised to make new highs in the coming days, with the long awaited earnings growth finally trickling in. You could argue that the advent of India’s boom days was delayed by around two fiscals due to the nationwide disruption caused by the demonetization and GST implementation and now that the dust has finally settled, the growth should lift off. While that theory may be logically sound, there’s just one problem. India happens to be a $2.6tn midget against a $19tn USA, or even a $13tn China for that matter, and it goes without saying that the US market controls the destiny of other markets worldwide.

     The fourth quarter of 2018 brought in some amount of global volatility and India’s political scene compounded the problem, with uncertainty clouding the outcomes of both state elections and the upcoming 2019 central elections. An interesting indicator of economic activity has traditionally been Indian M&A and more specifically, outbound M&A. While the former and latter are both surging, the sharp rise in the latter has always been a precursor to global markets entering a downturn as Indian companies are notorious for executing foreign acquisitions at the top of the market. And of course, despite the strong domestic institutional and retail participation in any pullback in the Indian markets, foreign investors still call the shots and navigate the flow of our equity markets. While FIIs have pulled out money from India during short bouts of uncertainty in the USA, sending India’s markets down close to 10%, the damage that they could cause by a full-scale withdrawal from India if the American markets tank would surely send the Indian markets into a downward spiral. And that might be the exact story that seems likely to play out in 2019.

      All in all, while the US economy seems fairly robust at the moment, the wheels that are going to drive it into the next downturn have already been set in motion. While one might question the lack of a trigger for the onset of the next recession, it goes without saying that such an absolutely perfect storm of the Fed raising interest rates, US unemployment dipping below 4%, surging realty prices, an ongoing global trade war, an imminent Brexit, companies overpaying for acquisitions and expensive stock markets around the world that have recorded a decade-long bull run would indeed be the concoction that sends the financial world crashing.

     It doesn’t take much for the fear epidemic to spread. After all, take a look at Germany. Europe’s most resilient economy, which was widely touted to be the only global economy firing on all cylinders over the past few years, with record surpluses and near zero unemployment is now rumoured to be entering a recession in just over six months’ time. What was the trigger, you might ask? One quarter of negative economic growth and falling automobile sales, both of which had been rock solid up until that fateful quarter. With Italy’s debt worries, France’s labour strikes and unimpressive growth, Brexit fallouts and the rest of Europe not exactly being in great financial health, smoke signals of a recession emanating from Berlin just so happen to be the last thing that Europe needs at the moment. Indeed, so much for German efficiency.

     Despite the current strength in most pockets and uncertainty hanging over other parts of the global economy, equity markets are generally the first to react, even before global economies enter a downturn. After all, equity markets downturns are known to predate economic recessions by around 6 to 8 months. The next 12 months are indeed going to be challenging, as far as the stock markets go, with several global economies poised on the precipice, leading up to what could very well be a global bear hug.

      A leading equity house in India goes by the saying ‘Buy Right, Sit Tight’. While that may indeed be a perfect strategy to follow after a market crash, it may hardly be the ideal move at this stage. Especially when, while the bull may be on steroids and running wild, a crouching bear may indeed be lying in wait to blindside the rampaging bull and claw it to the ground.