Finding value in an ‘overpriced’ market after the Pandemic disaster–SurprisingV-turn recovery is a tough task.

The miraculous recovery in the Bourses for the last few months has been unprecedented and unique. The investors are really flabbergasted to find the markets are scaling new heights day in day out. Naturally the market over-heated .While the Bulls are delighted and reaping the harvests, the Bears are awaiting a great bubble to burst. Will it happen is a million-dollar question. But the fact remains that many shares have seen new peaks and FIIs, DIIs and HNIs wonder whether this will sustain as the valuations are quite high in some cases unreasonably so, without reflecting the real and intrinsic value of them. For the last two days the markets have slided substantially and the fact that the FIIs have been net sellers proves our apprehension as above. The PE ratios are surging to unprecedented levels and hence investors will be wise enough to leverage the present hike in valuations by booking the profits and calibrate their investments in a way that there is no big capital erosion even after the markets see a free-fall as being expected by some Bears. The FIIs and Fund Managers also of the opinion that this market will not sustain for long as the valuations are too high uphold.Hence investors will play the game with helmet or safety-gear on during the few weeks to come. Even Global equities have been on a tear since the market bottomed out in the wake of the onset of the COVID-19 pandemic. Experts said the market crash early last year would -problem caused the crash. And yet, the ferocity of the bounce back surprised many and naturally so.

Valuations are a function of two things. Expectations of future earnings and the risk-free rate. Remember that earnings themselves are partly a function of the risk-free rate. Low hurdle rates and cost of capital for companies means more propensity to invest and earn. The expansion in valuations is visible in all key metrics:PE, price-to-book, price-to-sales. Valuations of startups too edged up sharply. This was evident in deal counts, ticket sizes and the number of IPOs that hit the market.

The pandemic affected the stock market in two ways. One, lockdowns imposed to tame the pandemic had a varying impact on sectors. Tourism, hospitality and aviation saw business fall off a cliff overnight. While digital transformation, according to some experts, advanced as much in three months as it would have in five years.

But there was a second, bigger impact. In their pandemic response, governments launched their most potent policy tool: money printing. A McKinsey report says in the first two months, governments put over $10 trillion into their economies. “For some countries, their response as a percentage of GDP was nearly ten times what it was in the financial crisis of 2008–09,” the McKinsey report says.

Liquidity wave

The combination of low rates, quantitative easing, credit guarantee schemes andstimulus checks resulted in a massive liquidity wave. Which likely found its way into markets, both public and private. The resulting stock rally meant that valuations became the highest they have been in a long time. For instance, Nobel Laureate Robert Shiller’s cyclically-adjusted PE (CAPE) ratio is the highest it has been in 150 years, except for a parabolic burst during the dotcom bubble.

A new market?  This begets the question: What does this mean for investors, both old and new?

So, when the market is trading at steep valuations, it is factoring in a sharp pick-up in earnings in the years ahead. Investors expect that such a catch-up would normalize valuation ratios.  Low rates also skew risk appetite by moving capital away from fixed income and into equities. (See below chart for the historical Fed Funds Rate).Such policies can make investing look a bit more daunting. For instance, value investors struggle to reconcile valuations with their own earnings outlook.  An investor trained in the school of Graham & Dodd would want to pick stocks at the lower end of the PE ratio. But today, they would be hard-pressed to find a bargain.

What would Buffett do? This is clear in the approach followed by Warren Buffett, Graham’s greatest disciple. Today, Buffett’s Berkshire Hathaway is sitting on a cash

pile of about $150 billion. Unsurprisingly, Berkshire’s stock has been underperforming the market for a long time. But one can look at Buffett himself to look for cues on how to approach this market. His investing approach has changed both over the course of his career, and over the past few years.  For instance, Buffett cites one important reason for his success. His partner Charlie Munger nudged him from looking for average companies at great prices into buying “great businesses at fair prices”. This change allowed Buffett to pick up and stay invested in the likes of Coca-Cola and Gillette. Two, even Buffett has realized the importance of investing in technology businesses. This is seen in his purchases of IBM and later, Apple.

Conclusion ; The takeaway from all this is clear. Stock prices have been trading at elevated levels. And it’s always difficult to predict what they will do in the near term: go up, down or remain sideways.

But if you are an investor, you must approach investing with guarded optimism. And these three rules will likely hold you in good stead. 1: Technological disruption is here to stay. 2: Great businesses will continue to do well, irrespective of the economic environment. And 3: thanks to global fiscal policies, economic cycles have likely become sharper. And risks of Black Swans have risen.  As investors, you will need to stay the course. But be more vigilant not only towards threats but also opportunities.