1 Jul, 2008, 1321 hrs IST
There is much to be said for the 'efficient market hypothesis' which states markets are generally both rational and efficient, and serve as reasonable leading indicators of economic and corporate developments.
Nonetheless, as investment professionals, we must continue to make informed judgements about where the market is headed, based on both our investment experience and using historical data. This is always a useful exercise.
The Indian market went through an impressive five-year bull market, beginning in 2003 and running until January 2008, fuelled by over $50 billion in FII inflows. During this period, corporate earnings surged at an unprecedented annualised rate of 32%, while multiples expanded from 9x to 19x at their recent peak.
Unfortunately, since then, India's market sell-off has been equally intense, accompanied by higher credit costs, inflation, lower industrial production, and several high-profile earnings disappointments. Although recent quarterly earnings growth has remained high, the trend has been one of QoQ deceleration, with contracting EBITDA margins (23% vs 26% last year) and net profit growth of 22% compared to 32% last year.
And rising commodity prices, particularly oil, of which India is a net importer, are likely to strain margins and earnings growth for the foreseeable future. It is instructive to look at India's high inflation environment in the mid-1990s.
In 1994, inflation was high at 10.8% compared to today's 11.42%, and the market was trading at similarly high P/E multiples of 23x. A very sharp correction of over 40% and a de-rating of the market P/E to around 13x soon followed.
Today, by contrast, market multiples have already contracted to 14x. Moreover, in addition to lower inflation, today's GDP growth is forecast at 7%+, versus only 6.3% in 1994. In short, a strong argument can be made that the economy, as well as the market, are in better shape today.
Nevertheless, the situation could quickly worsen if oil prices continue to rise. India's net imports of oil as a percentage of GDP is likely to rise to 6% this year, and research shows that every 10% increase in oil prices can shave off at least 0.1% in GDP growth and add 0.4% more inflation. Much, then, depends on where oil prices are heading, not something anyone can confidently predict.
It can also be helpful to examine the US market performance during the 1970s and '80s, when high inflation, spiking oil prices, and slowing growth (i.e., stagflation) all first appeared. Of course, there were many other unique political events affecting the market then, Watergate and the Iran-Contra affair, to name just two, but it's still useful to see how the US market responded to similar conditions.
The Dow remained volatile, but often traded within a tight range for most of this era, posting an annualised real rate of return of only 5% between 1970 and '89. India, a volatile market, tends to suffer more pronounced corrections (and rebounds) than other markets.
So has the Indian market survived this correction, or can it de-rate further to, say, a 10x multiple, like in 2003? Past bear markets in India have fallen 40- 55%, while MSCI India has already fallen 40% since December 2007. On the plus side, an argument can be made that India's corporate sector today is stronger, deeper, and better positioned to weather this slowdown than in the past.
In addition, though the economy is not without challenges, with the exception of the oil price, many of these appear less daunting than they have in the past. Combined with a growth to valuation profile that remains attractive relative to global peers, we would argue, the Indian market can avoid a further significant de-rating, unless commodity prices continue to rise.
Nevertheless, we would hasten to add that any immediate upside is also unlikely. Absent improvement on the global market front, the Indian market is likely, more than anything else, to be range-bound.
Ever since markets slid precipitously in January and continued on the downward turn, one has been wondering if the market has fallen enough to see a sustainable trend reversal. Amidst around 7,000 point fall in sensex from January peak till date, there have been as many as four 1,000-point rallies, including a 20% rise from mid-March low to end-April high.
Thus, there have been a few bottoms so to speak, and bottom-hunting so far has been a rather unprofitable enterprise with many false starts. Continuing the risky pursuit even then, there are multiple ways to approach this question of bottom.
For most of us though, given the odds of getting peaks and troughs right, the best way, of course, is to evolve an approach that does not effectively depend on searching for tops and bottoms. From a fundamental perspective, trajectory in corporate earnings is the most significant variable that will decide the long-term direction of the market.
Corporate earnings in India have grown at almost twice the pace of GDP in the last five years, and the market's expectations are that earnings growth trend is intact; only the extent of growth in the medium-term is made uncertain by recent macro-economic developments. The most important such development is the change in short-term inflation expectations in the recent past, and which has resulted in a change in the direction of interest rate movement.
To what levels inflation could rise and when it might start showing declining trend is in some way linked to trend in prices of global commodities, chiefly oil. As things stand today, there are reasons to believe that inflation is likely to cool down towards the last quarter and may take a little longer to come within the policymakers' tolerance band.
We believe that for clarity to emerge on the impact of the macro-economic challenges on aggregate corporate earnings it will take another 3-6 months. Some clarity will emerge in the upcoming first quarter results, but for more we may have to wait till second quarter's earnings reports to come.
While the macroeconomic news flow could remain mixed in the near future, one need not wait for the last of the bad news to come out of the bag, as in any case one can never be completely sure, a priori, to make an investment.
Incidentally, despite all the concerns expressed around India, GDP growth is expected in the range of 8% this fiscal and that should still rank us amongst the fastest growing economies in the world.
The most important lesson from history one can learn about equities is that one should not base one's investment decisions based on prevailing sentiment, feel good factor or lack of it. There is ample evidence in history to show that market bottoms out much before bad news ends, as markets discount future news into current prices or valuations.
The valuation of Indian equity market has corrected sharply from almost 20-21 times one-year forward to close to 13 times, whereas over last five years market has consistently traded in mid-teens range. Clearly a lot of bad news is already in the price.
Of the many amongst us who wish to time the bottom, only a few will succeed and even fewer on a consistent basis, while almost all of us need to save for future and on a regular basis.
So instead of trying to time the bottom, a better approach would be to systematically invest in a combination of assets that gives us the best chance of meeting our financial goals, which must also include outperforming long-term inflation to protect real value of savings as one of the key objectives. For the reasons discussed above, this is clearly an opportune time to be buying equities for the long-term.
Nevertheless, the situation could quickly worsen if oil prices continue to rise. India's net imports of oil as a percentage of GDP is likely to rise to 6% this year, and research shows that every 10% increase in oil prices can shave off at least 0.1% in GDP growth and add 0.4% more inflation. Much, then, depends on where oil prices are heading, not something anyone can confidently predict.
It can also be helpful to examine the US market performance during the 1970s and '80s, when high inflation, spiking oil prices, and slowing growth (i.e., stagflation) all first appeared. Of course, there were many other unique political events affecting the market then, Watergate and the Iran-Contra affair, to name just two, but it's still useful to see how the US market responded to similar conditions.
The Dow remained volatile, but often traded within a tight range for most of this era, posting an annualised real rate of return of only 5% between 1970 and '89. India, a volatile market, tends to suffer more pronounced corrections (and rebounds) than other markets.
So has the Indian market survived this correction, or can it de-rate further to, say, a 10x multiple, like in 2003? Past bear markets in India have fallen 40- 55%, while MSCI India has already fallen 40% since December 2007. On the plus side, an argument can be made that India's corporate sector today is stronger, deeper, and better positioned to weather this slowdown than in the past.
In addition, though the economy is not without challenges, with the exception of the oil price, many of these appear less daunting than they have in the past. Combined with a growth to valuation profile that remains attractive relative to global peers, we would argue, the Indian market can avoid a further significant de-rating, unless commodity prices continue to rise.
Nevertheless, we would hasten to add that any immediate upside is also unlikely. Absent improvement on the global market front, the Indian market is likely, more than anything else, to be range-bound.
Ever since markets slid precipitously in January and continued on the downward turn, one has been wondering if the market has fallen enough to see a sustainable trend reversal. Amidst around 7,000 point fall in sensex from January peak till date, there have been as many as four 1,000-point rallies, including a 20% rise from mid-March low to end-April high.
Thus, there have been a few bottoms so to speak, and bottom-hunting so far has been a rather unprofitable enterprise with many false starts. Continuing the risky pursuit even then, there are multiple ways to approach this question of bottom.
For most of us though, given the odds of getting peaks and troughs right, the best way, of course, is to evolve an approach that does not effectively depend on searching for tops and bottoms. From a fundamental perspective, trajectory in corporate earnings is the most significant variable that will decide the long-term direction of the market.
Corporate earnings in India have grown at almost twice the pace of GDP in the last five years, and the market's expectations are that earnings growth trend is intact; only the extent of growth in the medium-term is made uncertain by recent macro-economic developments. The most important such development is the change in short-term inflation expectations in the recent past, and which has resulted in a change in the direction of interest rate movement.
To what levels inflation could rise and when it might start showing declining trend is in some way linked to trend in prices of global commodities, chiefly oil. As things stand today, there are reasons to believe that inflation is likely to cool down towards the last quarter and may take a little longer to come within the policymakers' tolerance band.
We believe that for clarity to emerge on the impact of the macro-economic challenges on aggregate corporate earnings it will take another 3-6 months. Some clarity will emerge in the upcoming first quarter results, but for more we may have to wait till second quarter's earnings reports to come.
While the macroeconomic news flow could remain mixed in the near future, one need not wait for the last of the bad news to come out of the bag, as in any case one can never be completely sure, a priori, to make an investment.
Incidentally, despite all the concerns expressed around India, GDP growth is expected in the range of 8% this fiscal and that should still rank us amongst the fastest growing economies in the world.
The most important lesson from history one can learn about equities is that one should not base one's investment decisions based on prevailing sentiment, feel good factor or lack of it. There is ample evidence in history to show that market bottoms out much before bad news ends, as markets discount future news into current prices or valuations.
The valuation of Indian equity market has corrected sharply from almost 20-21 times one-year forward to close to 13 times, whereas over last five years market has consistently traded in mid-teens range. Clearly a lot of bad news is already in the price.
Of the many amongst us who wish to time the bottom, only a few will succeed and even fewer on a consistent basis, while almost all of us need to save for future and on a regular basis.
So instead of trying to time the bottom, a better approach would be to systematically invest in a combination of assets that gives us the best chance of meeting our financial goals, which must also include outperforming long-term inflation to protect real value of savings as one of the key objectives. For the reasons discussed above, this is clearly an opportune time to be buying equities for the long-term.
Indian economy has grown at an average 8.8% since FY04 compared to global GDP growth of around 4.5%. Robust domestic demand, higher productivity and increased global footprint have resulted in Indian corporates delivering over 25% earnings CAGR over FY04-08 period. In past five years sensex has more than quadrupled resulting in massive wealth creation for investors.
However, last six months have been a challenging time for Indian equity investors with series of negative events culminating at the same time, high commodity prices leading to higher inflation and interest rates, increased risk aversion resulting in emerging market sell-offs, political uncertainty, high fiscal deficit (including oil, fertiliser subsidies) etc.
India has been able to showcase a total turnaround in not just economic growth but in most factors of growth like literacy level, poverty level, industrialisation and others. India's demographic advantage has been highlighted time and again over the course of past few years.
India's capex and consumption cycle still remains in place in spite of the recent blips faced on macro economic front. Investment-led employment creation would feed a virtuous cycle of rising incomes and domestic consumption which in our view would dwarf the current scale of corporate activities.
In the short run we may see some moderation in the growth rates but over medium-to-longer term the trend GDP growth is likely to sustain at around 8% levels, if not higher. The current market valuations (BSE sensex) are comparable to other emerging markets despite their slower economic growth and lower return on equities (RoEs).
Sensex is down by over 33% from the peak while some of the mid-cap and small-cap stocks are down by over 50-60%. In search of bottom, investors tend to forget that the basic principle of equity investment is to have a 3-5 years investment horizon.
The question which investors should ask is whether Indian economy and thereby Indian corporates will able to withstand the near-term pressure and deliver longer-term growth. We believe that with a strong balance sheet and competitive cost structure, Indian corporates are as of now better placed to face near-term challenges. It is the trying times that will separate companies with superior management skills from the also-rans.
Bottom in stock markets can be spotted only with the advantage of hindsight. Crowd sentiments are often fickle and extremely difficult, if not impossible, to gauge. It is vital to understand that for a long-term investor, risk is not represented by stock price volatility; rather it lies in a firm's business and the economy it operates in. Interestingly, so do the opportunities!
If one were to take a years' perspective, most of the negative issues currently surrounding the Indian equities might have subsided. Global slowdown in demand is likely to have an impact on commodity prices, which in turn could bring down inflation to an acceptable level. As and when this happens it is likely to result in a change in the monetary policy, which currently has a tightening bias. The overhang of political uncertainty will be over along with general elections.
The deep pessimism surrounding the markets has made valuations attractive. In fact, some stocks are trading at bargain prices. These opportunities arise only in such uncertain times and for a long-term investor the current market offers excellent risk reward opportunity. For retail investors, we believe, systematic investment plan (SIP) is the best option to stay invested in the market.
However, last six months have been a challenging time for Indian equity investors with series of negative events culminating at the same time, high commodity prices leading to higher inflation and interest rates, increased risk aversion resulting in emerging market sell-offs, political uncertainty, high fiscal deficit (including oil, fertiliser subsidies) etc.
India has been able to showcase a total turnaround in not just economic growth but in most factors of growth like literacy level, poverty level, industrialisation and others. India's demographic advantage has been highlighted time and again over the course of past few years.
India's capex and consumption cycle still remains in place in spite of the recent blips faced on macro economic front. Investment-led employment creation would feed a virtuous cycle of rising incomes and domestic consumption which in our view would dwarf the current scale of corporate activities.
In the short run we may see some moderation in the growth rates but over medium-to-longer term the trend GDP growth is likely to sustain at around 8% levels, if not higher. The current market valuations (BSE sensex) are comparable to other emerging markets despite their slower economic growth and lower return on equities (RoEs).
Sensex is down by over 33% from the peak while some of the mid-cap and small-cap stocks are down by over 50-60%. In search of bottom, investors tend to forget that the basic principle of equity investment is to have a 3-5 years investment horizon.
The question which investors should ask is whether Indian economy and thereby Indian corporates will able to withstand the near-term pressure and deliver longer-term growth. We believe that with a strong balance sheet and competitive cost structure, Indian corporates are as of now better placed to face near-term challenges. It is the trying times that will separate companies with superior management skills from the also-rans.
Bottom in stock markets can be spotted only with the advantage of hindsight. Crowd sentiments are often fickle and extremely difficult, if not impossible, to gauge. It is vital to understand that for a long-term investor, risk is not represented by stock price volatility; rather it lies in a firm's business and the economy it operates in. Interestingly, so do the opportunities!
If one were to take a years' perspective, most of the negative issues currently surrounding the Indian equities might have subsided. Global slowdown in demand is likely to have an impact on commodity prices, which in turn could bring down inflation to an acceptable level. As and when this happens it is likely to result in a change in the monetary policy, which currently has a tightening bias. The overhang of political uncertainty will be over along with general elections.
The deep pessimism surrounding the markets has made valuations attractive. In fact, some stocks are trading at bargain prices. These opportunities arise only in such uncertain times and for a long-term investor the current market offers excellent risk reward opportunity. For retail investors, we believe, systematic investment plan (SIP) is the best option to stay invested in the market.
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