AS HEADWINDS BECOME TAILWINDS

The last year was a tough year for the Indian markets for more reasons than one. The impact of the US slowdown as well as Euro zone issues was generic to everyone globally, however the specific issues that were headwinds in the last calendar year are now providing tailwinds for the markets and it is possible that these tailwinds become stronger as the year progresses.

My last article was at a time of extreme pessimism, sentiments seem to be a bit better now after a 10% market up move, however the underlying pessimism and a disbelief in what is happening is all pervasive. I just completed a visit to Gujarat; traditionally a market of bulls and the kind of extreme pessimism I saw all around further reinforced my view that the year 2012 on an overall basis will be a good year. The three most important Headwinds of last year were

High inflation leading to high interest rates – The inflation cycle has clearly reversed. The reversal would have come a bit earlier were it not for the unprecedented fall in the value of the rupee in the last 4 months of 2011. Inflation has come off sharply in December and we are likely to see a further fall off over the next few months. The figure for January in all probability will go below 7%. RBI has refused to cut rates or CRR till now but has changed its monetary policy stance quite clearly by undertaking significant amount of OMO’s. The huge up move in the global commodity cycle has stalled with sharp correction in a large number of commodities. The impact was not felt on the manufacturing inflation in India due to the fall in the rupee. However we will start seeing the impact from February onwards. As such we will see interest rates and liquidity continue to improve from here till the end of the year 2012. This will provide impetus to both consumption and investment demand which got stalled last year due to various reasons which included continually increasing interest rates.

No policy initiative- A lot has already been written on this so I will not write more. However in reality last year decision making came to a standstill and impacted investments across sectors. Over the last few days we have seen initiatives on Retail FDI, Aviation FDI as well as on power sector woes. I believe that this process will further pick up post election in February. From its absolute bottom we should see significant improvement during this year and the expectations today are so low that small initiatives will be taken positively.

The Rupee movement – The movement of the Indian Rupee became the final nail in the coffin last year end. The unprecedented fall by over 20% shook the confidence of investors and also impacted companies with Forex liabilities adversely. However the INR has reversed direction in line with my expectations but at a pace faster than what I expected this year. We have already seen a 5% plus appreciation since the beginning of the year. Typically INR appreciation cycles and stock market movements are positively correlated and we are seeing signs of that in the current month.  The stated policy of the central bank is that they will not provide a direction to the currency but will reduce volatility. However that does not seem to be happening on either side. Overall prospects for the rupee continue to be constructive, however the pace of appreciation should slow down and there is an increased likelihood of two way movements with reduced volatility going forward.

As such the three major headwinds are now tailwinds for the markets. Typically in bearish phases of the markets the markets will always surprise us on the downside and similarly on up moves there are likely to be upside surprises.

Some areas of concern still remain which include the high Fiscal Deficit and the measures taken to address the same. Increasing taxes will be a retrograde step, as in a slowing economy increasing taxes will cause inflation and hurt growth. Steps should be more on the expenditure side. Growth boosting measures will also be constructive for the Fiscal deficit as it will boost government revenues. Although lot of armchair economist will push for higher taxes that is clearly not the way to go. Tax increases will further curtail demand and as a result of that the expected revenues from higher taxes will not flow through as both top line and bottom-line growth gets compromised. The time to address the fiscal deficit in right earnest will be in a recovery cycle as that is the time harsh decisions get adapted in the momentum of growth. An extreme example of this is seen in the Euro zone where troubled countries are being forced to under take austerity measures, however due to its negative impact on growth the Fiscal Deficit targets are going way off mark. Maybe those countries have not option, however Emerging Economies like India do have that option as the nominal GDP growth even in the worst of times is expected to be 13-15%. How subsidies are addressed in the budget will be keenly watched.

Growing NPA’s in the banking system is also an area of concern. However a large amount of that can be addressed through policy measures. Most of the stress is coming from infrastructure sector investments where real assets exist. However they are in a situation where the expected returns are not flowing through and projects are stuck due to one reason or the other. These issues should be addressed to a great extent over the next 12 months. The consumer side & the unsecured side seem to be under control.

Results & Markets

Results till date have not played out to the doomsday scenario.  The early birds in the IT sector have shown mixed results which are not bad in the current global macro scenario. Banks seem to be doing better than expectations and some Auto companies that have reported have seen a decent set of numbers. A large number of companies are yet to report.

Markets have rallied sharply in the midst of extreme gloom and doom. We have seen a 10% up move from the bottom. The pace of the up move is clearly unsustainable; however what this move has done, along with the buyback announcement by Reliance Industries is that it seems to have clearly put a bottom to the markets around last years closing levels. Directionally markets still look constructive, especially in the broader market sense. I still stick with my view of this being a 15-25% kind of return year in the absence of any fresh cues to indicate otherwise. This will be a good year for stock pickers as macro concerns recede and investors start looking at pockets of value.

The interesting thing is that some markets globally already seem to be in a new bull phase. India and China do not fit into that right now and we need to evaluate things over the next few weeks to take a bigger call on the same.

Will write more soon as we get fresh indicators of where things could go.

2012

It is quite amazing but true that the year 2011 has been the second worst year in the history of Indian markets with a decline of 25% in the Nifty and 35% in the Mid cap indices(since the 1980s at least). No prizes for guessing which was the worst year i.e. 2008. In USD terms the performance was even more disastrous with losses of 44% given the 19% decline in the value of the INR. The year began with cautious optimism after the fall that the markets had seen post peaking off in November 2010. However a sequence of events, foreseeable and unforeseeable made this a disastrous year for equity investors. A lot will be written on the year ahead and I have touched on some subjects in my previous articles a few weeks back. However sentimentally one thing is very apparent from all the strategy reports that I read today, as well as the commentary in various media.

1. 2012 will be a very tough year for equity investors and it is unlikely that there will be significant returns during this year.
2. India will continue to underperform given concerns on inflation, high interest rates and poor governance.

I have infact not read more pessimistic commentary on India for a very long time as we see today. The same brokerages/research houses that were predicting Sensex at 23-24000 by the end of 2011 a year back are now forecasting markets at 12000 (at the lower range) to 18000 (at the median of the upper range). There are some who, albeit apologetically are predicting a move above 20,000 levels this year. However this is being done with a lot of caveats. The funniest are those reports where there are bull case, base case and bear case views where the difference between the bear case and the bull case is over 50-60%.

My take on the markets in 2012 is that we will see the Nifty/Sensex return anywhere between 15-25% and the broader markets by 25-35%. I believe that sentimentally the markets have bottomed out and the bottoming out, value wise will happen over the next few days or weeks. This should lead to a durable bottom being formed for the markets. I have touched on the logic for the same to a large extent in my article on the 5^th of December, an updated version of which I will present in brief and then more on the domestic situation and the markets.

The Euro zone Crisis – The Euro zone crisis and the debt issues related to Greece, Italy and Spain have been the main contributory factors to the nervousness in the global equity markets over the last several months. The crisis has got accented by a lack of faith in the political system and its ability to resolve the issues. This issue has been discussed a lot so I will not go into the details of all of this, however I do have a contrarian view on the future direction of news flow from Euro zone. We now have new governments in Italy, Spain and Greece i.e. all the troubled countries. Two of them are lead by technocrats and one by the right wing party. As such, in my view the worst of the news flow from Europe is now in and we might not get incremental negative news flow over the next 4-5 weeks. This is likely to be similar to the negativity due to news out of the US around 3-4 months back, which suddenly died out as the economic data started to improve. The entry of the IMF in the entire discussion combined with greater urgency to resolve the issues is also encouraging.  Overall I do not expect Europe to create any deep cuts in the markets going forward.  This was the view that I had put out a few weeks back and seems to have played out well. It seems clear now that although Euro zone will go through a cycle of deleveraging, slow growth, intermittent issues related to fiscal issues of troubled countries etc, the probability of a Euro zone breakup seems remote at this stage. Intermittent occasions of bond issuance of Italy and Spain will create volatility on those days. Infact if investors were so concerned on the Euro it would not have fallen by just 2-3% against the USD in the year 2011. As I wrote a couple of weeks back “Europe has clearly avoided its Lehman Moment”

US News flow – The news flow from the US has been mixed. Over the last few weeks there seemed to be clear indications of an improvement in economic activity. The Fiscal issues will keep on creating volatility periodically, however low borrowing costs and an improving economy could lead to a Fiscal surprise next year.Overall economic activity seems to be improving, albeit at a slow pace in the US and there does not seem to be the likelihood of a double dip recession at this stage. Most corporates in the US are cash rich and market valuations are at just around 11X P/E for next year. Earning expectations for the year 2012 are pretty low with earnings growth forecast in the range of 0-5%. As such US news flow will create volatility but it does not look that it can create a fresh down move at this stage.

Infact US has not only created conditions for a down move, but it has actually supported global markets due to continuously improving economic data, especially related to employment numbers. Technically too the movement of the key indices above 200DMA’s and the breakdown of the similarity of the move from 2008 indicates further gains for US equities. The breakdown of VIX below 23-24 levels also indicates reduced risk aversion and greater confidence. Typically such breakdowns are followed by multiweek up moves.

GOLD – As I have written in detail in my previous article I expect 2012 to be a difficult year for gold. I expect a 20-25% correction before prices come to a level where actual demand rather than pure investment demand can support prices. Since I have written in detail earlier I will not repeat, however the most fancied asset class will have a tough time holding on.

China – China is one aspect about which I have not written earlier mainly due to the fact that it is difficult to analyze it. However pessimism on China seems to be at its peak with the Chinese markets trading at valuations that are at multiyear lows. The expectations of some, of a hard landing in China do not seem to be playing out. The move from investment to consumption led growth seems to be moving slowly. By letting the Yuan appreciate in light of pressure on exports seems to have played out well. Inflation has also been controlled well by demand & supply led measures as well as administrative dictates (which can only work in that country and not in countries like India). The moderation in economic growth has been happening at a steady pace. However the key challenge will be holding up growth in light of falling export demand, controlling excessive investments in unproductive areas and the biggest factor will be the asset quality of Chinese banks and how they will hold up in light of increasingly challenging environment and pressure on profitability of Chinese corporates. The corporate sector in China is likely to be hit on two fronts i.e. higher wage costs due to rapidly increasing salaries as well as the strong up move of the Yuan against most other competing currencies. Just as an example, over the last one year the Indian rupee is down 20% against the USD and the Yuan is up nearly 6%. The way things look to me it seems the base case will be a soft landing rather than a hard landing for China in the near term. The two big surpluses that China has i.e. Current Account & Fiscal are vastly undervalued by the markets in my view. Officially China seems to be aiming at an 8% growth next year which is extremely strong in the current environment. The challenge is health of the banking system and how much it needs to be capitalized in order to support this growth as well as the state of health of the Provincial Governments about which there is very less transparency.

India domestic factors & outlook

The Indian markets had to make do with not only global issues but also several domestic issues in the year 2011 making it one of the most turbulent years in recent memory. Although 2008 was challenging for India, it was generally perceived at that stage that the factors are largely external and as such should not have a lasting impact on the performance of the economy. We had also started giving lesser importance to the government as the economy became more and more open. However 2011 was a year which showed the importance of governance in promoting and sustaining economic growth as well as macroeconomic stability. The year 2011 was a year of high inflation, high interest rates, lack of policy making as well as the most challenging year for the Indian rupee since 1992 (ex of 2008).

The Rupee - The fall in the rupee is being attributed to high current account and fiscal deficits, which is true to some extent. However it is more due to a lack of confidence in the economy in the near term as well as cash flow mismatches on exports and imports. This aspect is extremely important to understand. Given the way the rupee fell and the continuous statements by policy makers that we are helpless in managing the rupee all importers have run to hedge their positions and no exporter is hedging. This creates a very huge mismatch in the short run. Let me try to explain. India has exports of broadly USD 20 bn a year and imports of USD 30 bn. Now this is a gap of USD 10 bn which is bridged by invisible flows, capital receipts, foreign borrowings, FDI etc etc. Now in a situation where everyone believes that the rupee can only fall all importers want to hedge, however no exporter wants to do the same. This creates a huge mismatch in the short run till the export proceeds flow in after a period of 90-120 days. This also creates a tendency to delay export inflows in order to realize a better rupee value. This actually makes me believe that the first quarter of 2012 can be a good period for the INR as the panic fall period now seems to be over and export realizations will start to come in. Other measures like reduction in holding period of Government and Infrastructure bonds as well as higher interest rates on NRI deposits should boost inflows. My base case view will be for a 3-4 % rupee appreciation in the first quarter of 2012 unless and until there are huge capital outflows.

Policy making – Initially we had a period in late 2010 and early 2011 when a large number of projects got held up on environmental issues. Later on after the 2G issue we have seen a significant decline in project approvals, takeoffs etc. This has got exacerbated by the continuous increase in policy rates by the RBI which has made lot of projects unviable. Reform measures have also got stalled. I believe that we are now at the absolute nadir of the decision making cycle and things can only improve from here on. I expect this to happen post election in February after which things would be much better.

Inflation would have come off much more sharply had it not been for the decline in the rupee. However the absolute correction in commodities and food prices combines with the strong base effect will take inflation down to nearly 5% by March 2012. In case the rupee also appreciates as I expect it too the overall scenario could be much better in 2012. As such we should have improving liquidity and much lower interest rates as we go through 2012 and this will provide a tailwind for economic activity to pick up.

Markets

Taking most things into account and also taking into account the market psychology as well as valuations I am of the view that the current situation of the markets is akin to early 2009 where one could see only negativity and that was the time that markets bottomed. Valuations, especially of the broader markets are today nearing historic lows and the overall market is also trading at 12X 2013E earnings which is very attractive. My view of the markets over the next one year is that of a worst case of 14500-14800 for the Sensex (at 12X P/E) and 26000 as the best case (on a 20x P/E.) 

The markets are today trading at a Mcap/GDP of 50%; in the beginning of 2008 this had gone up to as high as 160%. The Profits to GDP ration of corporates goes through phases of compression and expansion. Right now both gross margins as well as net margins are suppressed due to the huge input cost pressure that we have seen over the last 18 months as well as high interest costs. This is likely to reverse over the next two years. Eventually the Market capitalization will move towards the 100% level to GDP, if not more. This will provide strong returns over the next 3-4 years.

Markets seem to have taken most negatives in their stride as of now. The risk reward is strongly in favor of investing into equities at this stage. As inflation falls and interest rates come down there will be a revival in the economy and growth prospects will start improving. The timing of the bottom formation is difficult to predict, however it will happen in weeks not months.

Markets should be able to return 15-25% at the middle of the pessimistic/optimistic range over the next one year. 

BEST WISHES TO EVERYONE AND HOPING FOR A GREAT 2012

GOLD – END OF CYCLE

Over the last few days I have become more and more convinced that the up cycle for gold is now coming to an end and we will see a significant correction in this commodity before prices stabilize and move up again. My conviction has become greater after I talked to a vast variety of Investment Advisors/Fund Managers/Investors in general and took their view on Gold and other Asset Classes. Not to my surprise the only commodity that everyone had a buy on was GOLD. Gold today has become the most overowned and oversold ( in terms of it being sold as an investment idea) commodity. Infact the data coming out of Indian Mutual funds is also reflective of the sentiment where the inflows into gold funds have been higher than that of Equity Funds for a number of months over the last six months. This is despite the fact that the total assets under equity funds are more than 20-30 times that of gold funds.

I was frankly waiting for the technicals to become supportive of the fundamental view before putting out this piece. This now seems to be happening with Gold breaking down from a Symmetrical Triangle reversal pattern ( which is normally a continuation pattern and is rarely a reversal pattern which makes it stronger). As the chart reflects, there is now a breakdown which should see Gold moving down sharply over the next few weeks.

 The biggest consumer of gold in the world has traditionally been India. It is likely that this will be the case going forward also, despite their being talk of China becoming the biggest consumer. The traditional jewellery demand in India is not  a fad or fashion but something that is ingrained in the Indian system. This is very different from buying into an asset class that is fancied and where the prices are continuously going up. The significant increase in gold prices over the last few months have bought physical gold demand in India to a virtual standstill. 

As per the data coming out of the World Gold Council Gold demand in the third quarter of 2011 reached 1,053.9 tonnes, an increase of 6% compared to the same period last year. This equates to US$57.7bn, an all-time high in value terms.

According to the World Gold Council’s Gold Demand Trends report for Q3 2011 this increase was driven by investment demand which rose by 33% year-on-year to 468.1 tonnes, The demand for physical demand for the traditional purposes fell by 15% in this quarter. Gold supply was 1,034.4 tonnes in the third quarter of 2011

Overall, Indian jewellery demand in Q3 saw a 26% decline in tonnage, when compared to the same quarter in 2010, to 125.3 tonnes.

The question then is, for how long can investment demand hold up the price of a commodity in light of falling end user demand. The most drastic example of this was the way in which oil prices fell in the year 2008 from levels of USD 150 to USD 30 in a period of just six months. That is not to say that such a thing is possible and likely in the case of gold However the truth of the matter also is that lot of investment demand  is trend following demand  and also exists because of the fear phycohsis that prevails globally today. Investment Advisors and asset allocators find it easy to sell Gold ETF’s to investors who are running scared of investing elsewhere. In a number of European countries investors are running scared to putting deposits in the banks of their own countries. Similarly, given the way global equity markets have performed and the kind of volatility that we have seen investors are unwilling to allocate much to equities at this stage. As a result deposits of banks perceived to be safe, bonds or Germany, UK and the US have become save haven investment plays. Besides this gold is perceived to be the reservoir of value (and not without reason). However investors investing into gold need to be clear of their expectations from this asset class. The probability that gold will yield much below what investors can earn via fixed deposits of banks in a country like India where 5 year deposits of the safest of banks yield near 10% is extremely high at this stage.

As gold prices start to first stagnate and then fall, there will not only be low incremental flows into gold linked investment products but there will also be outflows. A large number of Hedge funds that have built up significant long positions in gold might also go short as the trend reverses. Given the fact that the supply of gold continues to be strong this will ultimately lead to a period where there could be a sharp sell off in gold. The only saviours for gold at this stage are the Central Banks that continue to buy with the trend. As price correct even they will move out and further accelerate the correction.

Contrary to views of gold prices moving to USD 2500 etc. my view at this stage would be for a correction in prices by atleast 20-25% over the next one year.   

Europe seems to have avoided its Lehman moment, focus shifts to growth

The EU summit started with extremely low expectations and that was also reflected in the movement of the markets prior to the summit where most markets sold off going into the summit. This by itself was a good sign that post event; at least we will not have a severe market selloff.

The key takeaway as far as I am concerned s that the so called “Lehman Moment” has been avoided by the decisions taken at the summit and with the moves of the ECB. Although most people have taken the resolve of the ECB not to print money negatively I think that it is a positive move as money printing at a time when the overnight deposits with the ECB are at all time highs and the discount rate is 1% will only accelerate inflationary expectations without contributing significantly to growth. This was the very reason why the US FED decided not to go in for another QE at the end of the last one and opted for Operation Twist.  At that time also I had pointed out that it was a good move, however in the short run markets had taken it negatively, however its positive impact showed up after a few days.

The main concern in the Euro zone is not the availability of money but the lack of faith. In order to restore faith the new deal that has been proposed which will put strict limits as well as monitoring of Fiscal Deficits is a good move for the long run. Over the short run my view has been that with there now being Technocrat led governments in Greece and Italy and a new government in Spain there is unlikely to be any significant negative news flow from this part of the world over the next few months. The commentary that I read seems to suggest that the lack of offer from the ECB to buy large amounts of bonds is being taken negatively. However the key is that there needs to be a return of faith in the Euro’s future existence and once investors are convinced on that they the negativity will start reducing gradually. If the entire market is on one side and the ECB is on the other side, irrespective of how much they buy the markets will not turn. I believe that the key from here on is on implementation.

Directionally I believe that volatility in the markets should reduce as most key events are behind us now. From there on economic data will become more important.

In the Indian context this week is full of data with the Industrial Production data that came out today was in line with the number that came out in the Times of India a few days back at -5.1%. The consensus was for a half percent decline. Capital goods data has turned extremely negative with no new projects taking off.  Inflation data on Wednesday and Thursday & the RBI policy on Friday. No major economic decisions are likely from the governments’ side till the 21^st when the winter session of parliament comes to an end. Post that we could see the government becoming more serious on the economy. It is likely that economic activity would have bottomed out in India now, the key will be to  see the pace of revival. The revival will be slow given the way the economy has come to a standstill due to extremely tight liquidity conditions and high interest rates. Inflation out on Wednesday should be in the region of 8.6% vis a vis Reuters consensus of 9.04%. 

With global commodity prices ex of crude cooling off and food inflation coming off sharply we are likely to see a sharp decline in inflation in India over the next three months. This will set the tone for significant easing from the RBI. Interest rates a year from now should be at least 150-200 basis points lower from the current levels. This will be supportive of both consumption and investment demand. However lack of policy response to boost capital formation might lead to India continuing to underperform other Emerging Markets. Sentiments for investment into Indian equities is at its nadir today and the key is to see when the sentiments turnaround. Since early October when the markets bottomed out after their last selloff, key large EM's like Brazil, Korea, Hong Kong etc are up nearly 15% and India is almost flat, thus reflecting domestic growth concerns. 

It was interesting to read the panel discussion of ET NOW in the economic times today where most investors seemed to be on the pessimistic side. I remember attending a similar discussion in February 2009 where the sentiments were similar and the markets turned around within a few weeks of that. Let’s hope it is the same this time too. 

Current State of the markets, more near the bottom than the top

I would like to begin this piece by an interesting observation. Exactly around a year back a survey was done of around 50 India focused Fund Managers as to the direction of the markets in the year 2011, the survey revealed that more than 45 Fund Managers were of the view that the year 2011 will be one of strong gains and the median forecast for the Sensex and Nifty were 23000 & 6500. (Regardless to say the writer was also in the bullish camp with a target of 24000 & 6700). A similar survey was done a couple of weeks back in which more than 75% of FM’s were bearish and predicted a decline in the year 2012. This is very similar to the scenario I saw in early 2009 when most market participants were bearish and that year was one of the best years for the markets. My guess is that 2012 will be a good year for the markets as most concerns reduce in intensity and will set the tone for much bigger moves in the following years.

Indian markets have been in a free fall over several weeks where we saw the Sensex decline from a level around 18000 at the end of October to current levels of 15500 for the Sensex before bouncing back by around 1000 points. There have been several contributory factors for this the prominent among them and their future directions are as follows

The Euro zone Crisis – The Euro zone crisis and the debt issues related to Greece, Italy and Spain have been the main contributory factors to the nervousness in the global equity markets over the last several months. The crisis has got accented by a lack of faith in the political system and its ability to resolve the issues. This issue has been discussed a lot so I will not go into the details of all of this, however I do have a contrarian view on the future direction of news flow from Euro zone. We now have new governments in Italy, Spain and Greece i.e. all the troubled countries. Two of them are lead by technocrats and one by the right wing party. As such, in my view the worst of the news flow from Europe is now in and we might not get incremental negative news flow over the next 4-5 weeks. This is likely to be similar to the negativity due to news out of the US around 3-4 months back, which suddenly died out as the economic data started to improve. The entry of the IMF in the entire discussion combined with greater urgency to resolve the issues is also encouraging.  Overall I do not expect Europe to create any deep cuts in the markets going forward.

US News flow – The news flow from the US has been mixed. Over the last few weeks there seemed to be clear indications of an improvement in economic activity. However political issues related to budgetary cuts and the lack of cohesion between the two political parties in that country will keep on creating volatility periodically. However overall economic activity seems to be improving, albeit at a slow pace in the US and there does not seem to be the likelihood of a double dip recession at this stage. Most corporates in the US are cash rich and market valuations are at just around 10X P/E for next year. Earning expectations for the year 2012 are pretty low with earnings growth forecast in the range of 0-5%. As such US news flow will create volatility but it does not look that it can create a fresh down move at this stage.

Domestic Factors – I believe that the major reason for India’s underperformance vis a vis most other Emerging Markets has more to do with domestic factors rather than global ones. Some Emerging markets like Korea, Brazil etc have made significant positive formations technically. Markets like Australia are also similarly positioned.

A lack of policy making – Policy response from the government in light of the global factors as well as a drastic slowdown in investment demand in the country has been tepid to say the least. Governance has come to a standstill and no decisions seem to be taken. This has lead to a further slowdown in the economy on the top of global factors. There are some signs that the government is now seized of the crisis and is planning to restart some reforms and push some decisions. If this happens it will reduce the negativity to a great extent. However on an overall basis this aspect seems to have bottomed out at this stage and can only improve. Lack of policy making has also led to acceleration of the economic slowdown and reduced government revenues. This has had an impact of the government having to borrow more from the markets. As a result government bond yields moved up sharply before correcting over the last few days.

Constant monetary tightening in the midst of signs of clear slowdown – RBI has stood out as the only central bank that has continued to hike rates despite clear signs of a drastic growth slowdown and a very uncertain global environment. This has further accelerated the slowdown in the economy as the cost of funds has become prohibitive. For example the 3000 plus companies that reported results have seen interest costs move up by nearly 50%. The central bank has totally misread the impending economic slowdown as well as the fact that the drivers of inflation in India ex of food are mainly global in nature and as the global economy slows the inflation will come down sharply of its own. We will see this happening over the next six months where inflation will come down from 9.7% to 6% over the next 6 months.

Most central banks across EM’s have reversed their tightening policies and have begun interest rate cuts 3-4 months back. China has also cut Reserve ratios last week. Interest rates have become restrictive for growth and the liquidity shortfall in the system has also lead to a slowdown in credit flow. High interest rates are making projects unviable and have lead to working capital costs go up sharply for corporates.  The RBI has made the first move towards easing via their Open Market Operations. The next step should be a CRR cut. I believe that now this cycle is clearly likely to reverse and we will see interest rates cuts from the RBI much sooner than the general consensus. As rates start coming down markets will improve.

Sharp decline in the value of the Rupee – Most emerging market currencies fell sharply in the period July to September and the Rupee was one of the worst performing of the lot. However as the recovery set in over the last few weeks the Indian Rupee has continued to slide. The main reason for this is cited as the Current Account Deficit. However I really do not subscribe to that view as the Current Account deficit has not increased meaningfully for this to be the reason. The actual reason is the last of faith in the Indian Growth story in the short run. Just around a year back policy makers in India were talking of a huge deluge of Dollars and they were not sure how it will be handled.  Today we are in a totally reverse position where they have put up their hands and are saying that we cannot do anything to control the depreciation of the Rupee. Conceptually I am not in favor of intervention. However when a trade becomes a no brainer then policy makers need to take measures. FDI reforms are the need of the day and the flow of capital into the country needs to be eased significantly. However all said, at the current levels the probability of a major decline is low. As the rupee stabilizes we should see foreign investors becoming more confident about investing into India.  

Taking most things into account and also taking into account the market psychology as well as valuations I am of the view that the current situation of the markets is akin to early 2009 where one could see only negativity and that was the time that markets bottomed. Valuations, especially of the broader markets are today nearing historic lows and the overall market is also trading at 12X 2013E earnings which is very attractive. My view of the markets over the next one year is that of a worst case of 14800-15000 for the Sensex (at 12X P/E) and 26000 as the best case (on a 20x P/E. Markets are seem to have taken most negatives in their stride as of now. The risk reward is strongly in favor of investing into equities at this stage. As inflation falls and interest rates come down there will be a revival in the economy and growth prospects will start improving. 

Markets should be able to return 20-30% at the middle of the pessimistic/optimistic range over the next one year. 

A time for contrarian investing

As the markets flirted with their low levels during the course of this year the one thing that was missing was a feeling of complete capitulation and total apathy and panic setting into the markets. Although I had expected the lows of around 15500 for the Sensex and 4700 for the Nifty to hold and they have held till date none of these events earlier during the year saw a sharp unrestrained fall in mid cap stocks and also in a large number of infrastructure stocks which most investors had been holding on with the hope of a bounce back. This phenomenon has happened during the last few days and I have got a feeling in the market which is similar to the period of January/February 2009 before the markets formed a durable bottom and set the tone for the next up move. 

I believe that the markets are now ripe for contrarians investing as a vast majority of stocks are underperforming and it is only the high priced defensives that are outperforming. An analysis of the BSE 500 since the beginning of the year shows that out of 500 stocks only 90 are up and the rest of them are down for the year. —

So what is the basic tenet of Contra investing-?

Uncertainties emerge in global events, economic growth, government policy etc. All such events converging today, creating huge opportunity for generating future returns. Thus current environment is apt for contrarian investment

The reasons why a Contra strategy is apt at the current point of time are 

—Most funds/investors are betting on the safest stocks. Top holdings of mutual funds are all among the top 10 market capitalized companies in India and constitute over 30% of total equity holdings .When these stock don’t move, several MFs don’t perform in the short run and this kind of Risk Aversion prevents more creative stock selection.

—Majority of stocks have not performed in the last 12 months, although market is 20% down from the peak, several stocks are languishing much below their historic high

—Economic growth is bottoming out and fundamentals can only improve

—Significant fear clouds judgment and impedes value unlocking and Lot of high potential stocks cheaply available and a large number of well Several well established stocks have seen sharp P/E reduction showing loss of investors belief

Long term fundamentals of most of the stocks remain robust while there are short term challenges

All this has led to high under ownership in a vast majority of stocks. As a contrarian investor sudden drop in investor interest poses an entry opportunity.

—        As fundamentals change, the extent of under-ownership determines the speed of appreciation

—        A rightly timed investment into a under-owned stock can result in quick gains

—        Exit is easier when the herd comes in

The contrarian strategy is also applicable in investing over market capitalizations where mid caps/large cap premium and discount varies over periods of time depending on market sentiments. This switch between market capitalizations is also a contra strategy which is largely favoring mid caps at his stage.

The key is that contra investing is not value investing. The key is that when growth investing is contra one has to be a growth investor, when value is contra one has to go growth.

The contrarian investment theme is often confused with the fundamental or value investing. But it is a fallacy….It involves far more complex thought process. It is a way of thinking which is difficult to emulate.

•        Contra investing also requires incubating stocks for some time before they find favor with the rest of the market. Proactively identify new investment themes and build up strong positions before a majority of investors

•        It is also important to Monitor stock/sector ownership and relate it to the fundamentals of the sector. Get out of over owned stocks and get into under owned ones. Avoids momentum stocks and over owned sectors, thus improves risk profile

At this stage my key contra bets will be well established mid sized corporates which strong brand franchises or business franchise which might have some short term concerns that are leading to a severe mispricing of the long term potential. If one takes stocks with a market capitalization of at least Rs 1000 crores where stocks are down at least 60% from their peak values or the valuation discount from the peak valuations are at least 50% a portfolio of at least 20 high quality stocks can be easily built which on a buy and hold strategy can yield at least 100% over a two year holding period.

However while evaluating such companies it is also important to evaluate companies in a manner where there should not be a value trap as some companies specially in the infrastructure sector have destroyed their balance sheets via aggressive bidding and high Debt: Equity levels to such an extent that there is very little tangible equity value left in these companies, although the stocks might be cheap on a Price to Book basis.  Again to reiterate the value trap is the biggest folly in contrarian investing.

However on the flip side it is also true that post evaluation if one comes to the conclusion that as interest rates ease off and cash flows improve the debt burden can be reduced then one of the biggest equity value creations do happen via the shift of the total enterprise value from debt to equity while the overall enterprise value might not change. For example, let’s say there is a company with Debt+Equity of Rs 10000 Crores out of which, on today’s day Debt is Rs 8000 Cr and Equity is Rs 2000 Cr. Over the next couple of years it can happen that the overall company value does not change but Debt comes down to Rs 6000 Cr and Equity value goes upto Rs 4000 Crores. As such equity returns can be 100%.

In January 2008 India's market capitalization peaked at Rs 75 Lakh Crores and Market cap to GDP was at 160% & in March 2009 the Market Capitalization bottomed out at Rs 30 Lakh Crores.

Current Market capitalization stands at Rs 70 Lakh Crores and Market cap to GDP is at 77% on 2011-12 GDP & 65% on 2012-13.

—        Eventually as the bull market matures over the next 3-4 years, the Market cap to GDP should approach the earlier peaks.

—        India’s GDP in the year 2014-15 should be at Rs 135 Lakh crores.

—        Assuming a mature and peaking bull market at that stage the market capitalization could be at around Rs 200-220 Lakh crores.

—        This implies a tripling of Market Capitalization from the current levels over the next 4 years.

—        Per annum returns could be at an average of 25% plus.

—        The current bearishness and apathy towards equity could be one of the best entry points for the Indian markets

Since it’s already become a big note on Contrarian Investing I will write more on this subject later. However the value in the market is tremendous today and selective buys at these levels will generate huge returns over the next bull cycle. 

A New Beginning?

I have just come back from a Diwali break and had a good vacation. I did not miss much during my trip and most of the markets and stocks seem to be placed similarly as they were a couple of weeks back. The results season has progressed and in general has been quite decent given the low expectations that had got built up due to high inflationary pressures and poor economic data over the last three months.

One of the key facets of the results which have come out strongly is that consumers are still spending strongly even in an environment where inflation is near double digits. Consumer good companies have held or improved margins and reported strong nominal growth, although the volume growth has cooled down. Consumer Durables, especially that tend to get financed have seen some pressure and could see a further slowdown if interest rates remain high.

The complete inefficacy of RBI’s monetary tightening seems to have now been realized by the central bank and by making a statement towards no further tightening in the latest policy when reported inflation is still high and food inflation is at 9 month highs is a clear admission that the scope of inflation control does not lie in higher interest rates. Global commodities have cooled off over the last 3 months and a large number of commodities are now trading at or below levels of the same time last year. However the impact of this fall has got nullified in India to some extent due to the depreciation of the rupee. The INR is down by around 9.8% over the last one year and as per some studies a one percent appreciation/depreciation affects India’s WPI by around 0.3%. As such a 10% depreciation itself would contribute to a 3% increase in inflation. In other words if the INR had not depreciated the inflation would have been more near 7% than the current 9.7%.

The good part of the depreciation of the rupee has been that it has provided breathing space for the industry which has been reeling under high input and interest costs. The Chinese Yuan has appreciated by around 6% over the last one year and the INR has fallen by 10% thus providing an incremental competitive advantage of 16%, which is quite huge. Although skeptics have doubted the strong show by Indian exports over the last couple of years, one reason for the same is the improving competitiveness of Indian exporters in the global market place. With the Yuan set to appreciate further and with wage pressures being much greater in China than in India over the next 3-5 years Indian manufacturers across the board have a great opportunity to take away some market share from Chinese exporters. However policy support from the government in terms of ease of operations, better infrastructure and reduction in red tapisim will be required over the long run if India has to leverage its demographic dividend.

The twin deficits of Current account and Fiscal deficit have raised concerns with regards to India over the last few months. On the fiscal side things are unlikely to improve in the near term as government spending is largely inflexible and revenues are coming down due to a slowing economy. The inability of the government to go ahead with the disinvestment programme has also created a revenue gap that needs to be covered with greater market borrowings. This has had an impact on government bond yields which have gone up by nearly 0.5% since the announcement of additional borrowings last month. In order to avoid crowding out there have been relaxations on foreign borrowings as well as norms of FII’s investing into both government debt and corporate bonds over the last two months. The relaxations should help bring in an additional USD 10 billion of funds into the country till March and reduce crowding out to some extent. On the current account side things seem to be much better with the trade deficit being at levels of USD 9 billion for the last two months. If the current run rate persists then the trade deficit can be controlled at 6% of GDP and the Current account deficit at 2.5%.

The global situation

The global situation has seen pulls on both sides over the last one month. Whereas the news flow from Europe has been mixed i.e. sometimes positive and at other times negative the news flow as far as the US economy goes seems to be continuously improving albeit slowly. The data coming out of the US clearly indicates a low probability of double dip and a slow economic growth in the near term. Data on housing and on the jobs front has also showing incremental improvement.

Euro zone seems to be going through a phase of crisis of confidence where not only large money market and debt funds globally have sold out Euro zone sovereign debt, but even large Euro zone banks have cut down holdings in countries where there seems to be even a whiff of trouble. Recent results of European banks clearly show that most banks have been continuously writing off Greek debt and selling out Italian and Spanish debt. It is clear that ECB cannot absorb such huge amounts of selling. A leveraged EPSF with huge firepower is required to bring back some semblance of confidence. Given the fact that the Euro has held on pretty well it does not seem as if there is a huge outflow out of Euro zone as a whole. It is just a move towards safety. On an overall basis the negative news flow out of Europe seems to have peaked out now.

Markets

There are two aspects to the markets at this stage. The first is the downside risk, where it is clear to me that we seem to have made a very strong bottom at levels of 4700 for the Nifty which is unlikely to be breached anytime soon. Currently we are around 10% higher than those levels. There has been a significant time wise correction along with value correction in the markets. As investors have got frustrated most have got out of small & mid caps and most investors (who are left in the equity markets) are just concentrating on large caps. For confidence to come back it is necessary for markets to sustain at higher levels and as that happens we will again see money flow into the broader markets which seems to be very cheap relative to the large cap indices on an overall basis.

The second aspect is about the upside. My initial view was that we will see the markets retrace, at least 50% of its entire fall from last November levels. This leads to levels of around 5500 & 18300 for the Nifty and Sensex respectively. The pace of the subsequent up move will be dependant on the trajectory of inflation/interest rates as well policy initiatives from the government. Expectations for growth have come down substantially. When we started off this year the estimates were for an earnings growth of 20% for the current year and 25% for next year. Current estimates for next years growth have now come down to 16%, which seems to be fair in the context of lower input cost pressures going forward as well as our being at the peak of the interest rate cycle.

As such on an overall basis, it seems at this stage that most of the concerns are in the price. However any upside from an improving macro environment in 2012 is not being factored in at this stage. This gives me the confidence that 2012 will be a good year for he markets.

Astrologically speaking – I just could not resist writing this so here it goes. There is an extremely significant astrological phenomenon that takes place in the middle of November where the most powerful of planets i.e. Saturn moves into his strongest position as it moves into the sign of Libra. Libra is the sign where Saturn gets exalted and acts extremely positively. The discomfort that it felt during its last two transits in Leo and Virgo now will give way to a feeling of extreme comfort. The last time this phenomenon happened was in the period 1982-85 where it unleashed an extremely strong bull market which eventually ended with the crash of October 1987. A similar phenomenon is likely to recur over the next three years. However as Saturn is a slow moving planet it might take some time to give its fruits. Normally Saturn requires Jupiter to either conjoin or aspect it to trigger it off and given that both planets will face each other from November 2011 till May 2012 we should see the trigger sometime during this period. More on financial astrology later.

Purely fundamentally speaking we are more near the bottom of the market than near the top and the next year should be good for the markets. How good is a question that will be determined more by the pace at which data improves.