One simple explanation for inflation is an increase in money supply without a commensurate increase in supply of goods and services. If more money is chasing the same quantity of goods and services, prices must rise. This holds true even when it's money chasing other financial assets. Stocks, or bonds, or real estate -- the prices of assets rise if easy money is available.
In general, the world has seen easy money since the mid-1990s. It started with the US Federal Reserve Chairman Alan Greenspan's easy money policies in response to financial crises. Greenspan served as the world's most powerful central banker for a very long time. During his tenure, there were financial crises in Latin America, Russia and Asia. His response was to pump more money into the global system on each occasion.
After Greenspan retired, his successor, Ben Bernanke, tried the same methods with Quantitative Easing (QE) after the real estate sub-prime bubble burst. After various European nations went into crisis, America launched more rounds of QE. Japan launched a QE. The European Central Bank has also kept rates low. So has the Bank of England.
As a result of easy money for nearly two decades, averaged market valuations have gone up. This has interesting implications. Common used market valuation ratios such as the PE ratio, price-to-book valuations, etc, are mean-reverting. They meander around average values and those average values tend to remain constant over long periods.
Mean-reversion has some predictive value. The mathematical characteristics of mean-reverting normal distributions are well-known. For example, two-thirds of all values will tend to lie within one standard deviation of the mean, and close to 95 per cent of all values will lie within two standard deviations and over 99 per cent of values will be within three deviations. This rule tells us when some asset is unusually high-valued, or low-valued since it is far from the mean. For example, if the mean PE of an index is 18, and the standard deviation is two, the PE values will be within the range of 14-22 around 95 per cent of the time. If it's outside that 14-22 zone, there's a strong probability that valuations would soon start moving towards the mean.
However, it is dangerous to over-fit investment strategies to normal distribution curves. Financial assets often have very long tails. Unlike a classic normal distribution (which has 99.7 per cent of all values inside three standard deviations), financial valuation data can often have 1-2 per cent of extreme readings with values well beyond three standard deviations.
Since the mid-to-late 1990s, stock valuations have been consistently high in most First World markets. This has been true for bear markets where the lowest valuations hit have been higher than the lows of previous bear markets. It has been true for bull markets where the highest valuations are higher than the highest valuations reached in earlier bull markets.
There are some inferences investors can draw. One is that, unless there is a drastic change in central bank attitudes, money supply is unlikely to contract a great deal in the near future. Money supply will stay on the easy side, with global interest rates staying low, since most big central banks are inclined that way. Therefore, historic valuations must be adjusted upwards to some degree and investors must mentally adjust valuation expectations up. India is a somewhat exceptional case. Local interest rates are high because inflation has been out of step with global patterns. But the Indian stock market is also driven and influenced by FII investments and FIIs are part of the global easy money regime. FIIs tend to focus on big stocks in the derivatives segment, where there is also a domestic institutional presence of course.
Valuations in big stocks, therefore, tend to run in step with global trends. There is some evidence that average PE, PBV and other valuations have gone up for the top 300 stocks in terms of market capitalisation. Smaller stocks, which are tracked only by local retail, may well have different characteristics. But long-term valuation data are difficult to get for such small scrips. This also leads one to believe that there could be a major upside to the stock market if there is an economic recovery. The current PE of 20-21 for the large indices is just moderately above the mean values. We've seen periods of 27-28 PE on the Nifty and Nifty Junior in the past 10 years. If earnings grow, and PE also rises, there could be a huge upside.
