06 Feb 2018 17:18 IST

What led to the market crash

Wall Street crash has brought the bears roaring out of their lairs and there is a blood-bath in global markets

When the Sensex fell over 800 points on Friday, the fall was largely attributed to the re-introduction of the long-term capital gains tax in the Budget.

But soon after, there was a resounding crash in the US market on Friday, with the Dow declining 666 points. This was followed by a bigger 1,175 points drop in the Dow on Monday, its biggest drop-ever in points, though the in percentage terms, the 4 per cent drop was not the worst.

But the crash in US has brought the bears roaring out of their lairs and there is a blood-bath in global markets on Tuesday with stocks in India too bleeding heavily.

The volatility index, VIX, gained over 50 per cent as panic gripped traders; Yen has spiked due to safe haven demand and markets across Asia are down around 3-4 per cent.

What has brought about this change in black mood?

US bond yield

One reason for the non-stop rally in US stocks was the low bond yields that made stocks relatively more attractive. But since stocks carry higher risk, a spike in bond yields makes investors pull money out of stocks to invest in bonds.

On Friday, US bond yields hit a four-year peak with the recent tax Bill of the Trump administration expected to lead to higher government borrowing that would in turn lead to higher supply of bonds. US 10-year bond yield has rallied from 2.1 per cent in September 2017 to 2.8 per cent this month.

Monetary tightening by central banks

The primary reason behind the stock markets across the globe moving higher in a breathless fashion in 2017 was global liquidity. But with growth in EU and US picking up, central banks, including the Fed have taken their foot off the pedal, as far as infusing liquidity in to markets goes.

The Fed has already begun hiking rates and has set out a clear-cut plan for selling the bonds it has purchased as part of quantitative easing. These measures will suck out further liquidity.

While these are major concerns, markets had been shrugging them aside, leading to the assumption that these events are already factored in to stock prices. But lesser liquidity is expected to pull the plug from under the market’s feet at some point or the other.

Stock prices moving beyond fundamentals

The other key factor destabilising stocks currently is the fact that speculative excessed have taken stock prices beyond their fundamental worth in the US.

The S&P 500 currently trades at a PE multiple of 25, the highest in the last 8 years. There was hardly any correction in 2017, as the Trump-led euphoria gripped markets. While earnings are growing in double-digits, come cool-off was expected.

Rally not supported by growth in India

In India, stock prices have been soaring higher even as earnings growth has been tepid, making valuation rich. The large-cap Nifty 50 index is currently trading at trailing 12-months Price Earning multiple of 23.8 times.

This valuation is more than the December 2007 PE multiple, at 22.5. But revenue and profit growth in the large cap segment is still in double digits, making this space comparatively safer.

Valuation in the Nifty Midcap 100 index and Nifty Smallcap 100 index are however much steeper at PE multiples of 46.6 and 115, respectively. While large-cap stocks are managing to show growth, revenue and profitability of many mid and small cap stocks have been hit by the ongoing slowdown and GST rollout.

But the principal risk to equity prices remains from the fact that prices have rallied ahead of earnings recovery. Lack of private capex, low utilisation in manufacturing units, stressed state of banks’ balance sheets, logjam in sectors such as power and real estate, structural issues in IT and regulatory run-ins in pharma are few problems dogging the key sectors.

Given these, a euphoric state in stock market was quite misplaced.

The long-term story of India is however still good. Buy selective large-cap stocks and pare exposure to mid and small-cap stocks with shaky fundamentals. You can get your shopping list ready for buying bluechips, now that the correction is here.

(The article first appeared in The Hindu BusinessLine.)