Does seasonality work in the stock markets

Historically I have never been a believer in stock market seasonality and would typically laugh off comments where people would recommend buying into particular months or selling into others. The most often used seasonal comment in the markets is "Sell in May and go away". However as I looked at data over the last 4 decades it more and more became clear that there is some seasonality in stock markets. Not that it always works, but it works in most cases. In-fact sell in May and go away came out to be the worst analysis of seasonal trends as an analysis of Indian Markets actually shows that the June to September period is the best period for the stock markets where nearly 50% of the returns of the average annual returns are made. 

The other interesting observation is that the returns that the stock markets gave, in terms of the movement of the BSE Sensex on an annual average basis was much higher in the years pre liberalization. For example, tha analysis of data from 1980 till the year 2012 indicates that the average annual returns from the markets have been 20%, however the data from 1992 onwards indicates that the average returns from the markets have fallen to around 14%. This is quite counterintutive in a sense as we would ideally believe that returns post economic liberalization would be higher. However data points otherwise. Infact the decade following 1992 was actually a lost decade for stock markets in India where the Sensex remained at a level of 3000 till the beginning of 2003 right where it was a decade back. However in this time period new sectors emerged that did create wealth for investors, specifically Technology and Indian Pharmaceutical companies along with a wide variety of FMCG companies. 

The broad data points are as follows

Average annual returns from 1980-2012           20%

Average annual returns form 1992-2012           14%

The reason why I broadly thought of looking at past data on seasonal market performance had to do with the broad recommendations coming out these days where investors are being advised to book profits on any rise rather than buy on dips. If History is any guide this is a time to buy on dips rather than sell on rallies. 

Broadly looking at data the following figures come out

Average June to September returns from 1980-2012           8.6%

Average June to September returns form 1992-2012           6.4%

Another interesting observation is that subsequent to this strong period typically Octobers are tough months where the average negative returns from the month of October has been -1.5%, competing closely with March to be the worst performing month. The logic behind such markets movements is difficult to comprehend. Maybe it is related to the summer holiday season where there is a reduction in activity and as such the probability of negative news flow is low. However we do remember the months of September is both the 9/11 attacks and the Lehman fiasco happened in that month. 

MARKETS

The stock markets have been reacting to global markets news flow as well as to the results season which has progressed with great gusto over the last three weeks. Positive results have been rewarded and negative ones punished severely. However on an overall basis the results season has passed off as a neutral one where we have seen selective Automobile, Private Sector Financials, Telecom & Pharmaceutical companies showing strong results. On the other hand the worst results have been from PSU Banks and Commodity companies, where the stress on the balance sheets is clearly visible in PSU Banks. Commodity companies are reeling under the stress of low demand & high interest rates. 

The bigger action has been on in the government bond markets where we have seen a sell off in developed market bonds and a rally in Indian bonds. Subsequent to the hawkish statements that RBI Governor Mr Subbarao put out after the last Monetary Policy meeting and the small bond sell off that followed we have had a huge rally in government bonds where the absolute returns from the 10 year bonds over the last two months has been nearly 5%. This is a reflection of the fact that RBI has not been able to forecast economic trends very well & a dangerous situation for the economy as policy is being framed under assumptions that are far away from reality. The absolute crash in the WPI inflation and the likely crash in CPI inflation over the next 5 months is for most people who can analyse data to see. 10 year bond yields have fallen from nearly 7.9% to 7.35%. In fact the new 10 year benchmark which was auctioned last week trades at 7.12%. 

In the meantime the favorite pastime of traders worldwide has become watching the movement of the Japanese markets and the Yen. Nikkei was  up 90% over the last 8 months before correcting by around 8% this week. The Yen has fallen 35% in the same time period. Nikkei whose movement would not even be noticed by most market players till Abenomics took ground might have become the most searched word on Google lately. As such Japanese markets that till sometime back had no impact on global market trading let to a crack in most markets this week. However the reality is that in the time when the Nikkei has almost doubled most emerging markets have been flat to up a few percentage points. Moreover the money printing by the Bank of Japan has just started and is likely to go on for a prolonged period of time. As such the Yen carry trade will only gain steam and not moderate going forward. 

As far as India goes the good part is that interest rates are definitely headed down going ahead, however the constraints to growth that come from government inaction still remain. Mr Chidambaram whose statements on reviving economic growth as well as reducing impediments for investments have been taken very positively by investors is also slowly losing credibility now. The lack of cohesion between various ministries is quite visible which impedes progress. The next few weeks, prior to the start of the monsoon session will be important from the perspective of government actions. The progress of the monsoon will also be closely watched over the next 15 days. 

The trend of the markets is clearly up, the pace of the upmove is however uncertain. The only significant risk in the near term comes from a correction in the US, German and Japanese markets that have rallied sharply even as Emerging Markets have languished. 

IS THE LONG TERM RALLY IN GLOBAL BONDS ACTUALLY OVER, MID MONTH UPDATE

The continued rally in the bonds of developed markets like US, Germany, UK etc has continued to intrigue most analysts over the last few years.  Some of the most prominent and well known bond investors gave a call over two years back that the two decade plus rally in global bonds is over for good. However, at that time the 10 year bond yields in the US were near the 3.8-4% mark. From there the US bond yields fell to below 1.5% as the US FED pursued its bond buying program with great vigor. Similar has been the movement in the bond yields of the other so called safe haven countries like the UK and Germany.  However, now that the economies in the developed world seem to be stabilizing and growth is picking up in the US there is a strong possibility that the US FED will start withdrawing the extremely accommodative monetary policies earlier rather than later. Credit conditions in the EU have also stabilized with the bond yields of the troubled countries like Italy, Spain etc now back to pre crisis levels and short term borrowing costs in these countries have fallen to all time lows.

This has happened in combination with the continuous up move in key global stock markets where US & German markets are now at all time highs and a number of other markets are at multiyear highs.  A market like Japan has rallied by nearly 80% over the last 6-7 months itself.  As a result of improving economic outlook, expectations of lower monetary stimulus as well as withdrawal of crisis measures we have seen bond of the “safe haven” countries sell off sharply over the last two weeks. This is quite contrary to what is happening in India where the sharp fall in inflation has led to a huge bond market rally.

Data actually suggests that the great rotation has not yet started in any big way. There is not much sign of money moving from bonds to equities, although incrementally equities are getting money now.  The key is that low interest rates have been one of the major reasons for the revival in the US economy and as such a sharp uptick in rates might lead to the recovery stalling. However the main point is how high a movement in interest rates is too high. As we see from the chart the major resistance on the upside is around the 2.4% range for 10 year US bonds.  It seems very likely that we will see the bond yields eventually move to that level over the next several weeks.  However, clearly looking at things both at a fundamental as well as technical level it seems too early to call an end to the long term bull market.  Fundamentally there are still issues related to poor job creation and high joblessness in most developed economies. Economic growth is still extremely anemic and is likely to remain subdued for an extended period of time. As such after the initial spike up from extremely low yields the further up move might be slow. Ultimately as we see from the long term bond yield chart the upper end of the downward sloping channel stands at around the 4% level and as such as long as the bonds trade in this range the long term trend is not really broken.  The realty also is that even after a sell off even till the 3.5-4% range interest rates will still be extremely low taking into account a long term perspective. As such recovery should not be stalled till rates move much higher as borrowing costs still remain constructive for growth.

Now if we go back to the last bull phase in equities we see that the bond yields went up from 3.1% in the year 2003 (when the bull phase started) to a level of around 5.2% till the third quarter of the year 2007. As such the move was around 2% from top to bottom. A similar move should happen over the next few quarters where the bond yields should move to the upper end of the channel. Normally such moves are accompanied by strong equity market rallies; let’s see how it plays out this time.

MID MONTH MARKET UPDATE

The first move where I had expected that the US and German markets will move to all time highs has fructified. As per a latest survey of fund managers it has been found that the overweight position on EM’s is very low and most investors have concentrated on DM’s. A shift in interest is imminent going forward and we should in all probability see Emerging Markets outperform over the course of the remainder of the year 2013. Obviously it does not mean that there will be no volatility, there should be bouts of volatility in between. The DOW is up 16%, DAX 9.5% & FTSE 13% YTD. Most BRIC’s markets are either flat, down or marginally up in the same time period.  As credit conditions become benign & risk taking increases we will see money move more into second tier markets.

In the Indian context the results season has been reasonably good relative to the extremely low expectations that were built up. As I had expected the WPI inflation has collapsed and will remain subdued for an extended period of time. The moderation in CPI has just started and we should see levels of 7% by July and 5.5% by September.

Contrary to RBI commentary, they will be forced to loosen monetary policy significantly. This in turn will be extremely positive for the revival of the economy as well as corporate earnings growth. The moderation in input costs has already had a positive impact on company margins, but for the operating leverage to come in we also need a revival in the economy that will boost the topline. The revival of the investment cycle requires more action from the government, the progress of which will be keenly watched. As such my base case assumption of a 15% return in the year 2013 seems to be on track. Upsides will depend on government action. 

ARE HIGH INTEREST RATES THE SOLUTION TO INDIA’S CAD PROBLEM

Over the course of the last three monetary policy statements the RBI has shifted the debate away from inflation to the Current Account Deficit. It is apparent that the slowdown in the upward spiral of food prices, the fall in global commodity prices by nearly 15-20% along with the total lack of pricing power with domestic manufacturers has led to a collapse in the moving average of inflation in the country. My expectation is that over the next three months we will see inflation collapse to 4.5%. Also contrary to what RBI says, the fall in demand combined with incremental capacity additions has now created a scenario in the country where there is enough surplus capacity in most industries both on the consumption as well as investment side. The areas where there is a shortfall, which is growing is in the area of raw minerals such as inputs for metals, coal, gas, petroleum products etc. Here the issue is of governance and getting projects which are on ground started and also pushing for investments in exploration activities. However this is something that we might not see in the course of the current government’s tenure. On the other hand, like I did write in a previous blog article the slowdown in the Chinese economy is creating a scenario where a large number of commodity prices might remain subdued for an extended period of time.

RBI along with the coterie of Armchair economists is propagating the logic of keeping interest rates high as the Trade Deficit needs to be funded and for that higher rates relative to the rest of the world will help us fund the deficit. The other risk factor that has been suddenly put out in the current policy has been that RBI is concerned with companies raising large amounts of ECB’s. However the reality is that if domestic interest rates are high & liquidity is kept persistently tight then what are the companies supposed to do. If the interest differential becomes as high as it is today where it is to the magnitude of 6-8% there will also be a greater propensity to keep the loans unhedged and expose themselves to forex risk i.e. of an INR depreciation.

What better time than now for a Sovereign Bond Issue

It is widely believed that it is RBI who has consistently opposed a Sovereign Bond Issuance. However my question is what better time will we get than today to raise fixed rate sovereign money. US 10 yr bonds today trade at 1.7%. The worst case for India to raise money at this stage when credit conditions are benign should be in the region of 3.5%. As a Sovereign the country can afford not to be hedged for a $ 20 billion borrowing which will be hardly 0.2% of GDP at the time of maturity. This will have three direct benefits, crowding out will be eliminated, government borrowing costs will come down & the INR will appreciate. Appreciation of the INR will have a direct impact on inflation which will trend down and give space to the RBI to reduce domestic rates. As such a strong virtuous cycle will start which will lead to significant growth revival. Today is the best time to raise USD funds for India as a Sovereign nation. RBI's stance here is difficult to understand.

If the country raises money & domestic liquidity improves then companies do not have to go and raise ECB’s and as such that risk will get eliminated.

The risks of keeping rates too high

What keeping interest rates high effectively does it to bring in more of debt money and short term funds into the country. What we actually need is more long term money to come into the country in the form of investments in real projects or into primary equity. However for this the investors need to have a positive perception of the economy and growth prospects. In this regard the RBI is obviously right when it says that monetary policy without supporting government policies cannot lead to economic revival. However by keeping rates high money is coming into the country in the form of debt or quasi debt which eventually needs to be repaid. A large number of structures are being set up all around for investing money into Indian debt instruments. This is a bigger risk that the RBI needs to realize.

In a slow global environment cheap suppliers credit or import credit to the buyers has become an important competitive tool over the last 3-4 years. On this front Indian manufacturers just cannot compete as the interest rate differentials are too high. In a different context, we saw that over the last few months in order to beat the slowdown luxury car makers from Europe offered extremely cheap credit terms in India to attract buyers. Volkswagen had a scheme where you can buy a car and pay after a year. Similarly Audi was providing funding at 2.99%. This is possible as these companies can borrow in their home countries at very cheap rates. For example for both Audi & Volkswagen companies the 5 year borrowing costs will not be more than 2%. In this context they can offer cheap funding from their global balance sheet in other countries too. However an Indian car manufacturer would have cost of funding more near the 10-11% range. As such in a globalized world with low barriers high interest rates create a competitive advantage for MNC's. 

Composition of the Trade Deficit makes it clear that boosting exports and FDI is the only way out

and also that high interest rates have no impact of the CAD

The composition of the Trade Deficit is such that Crude Oil imports and Gold imports are the two commodities which have been primarily responsible for the ballooning trade deficit. Besides this import of Edible Oil, Coal etc have also grown very rapidly in the last 5 years. On the other hand we have lost exports of Iron Ore to the tune of nearly $ 10 billion at current prices. Poor infrastructure, power shortages & increasing costs have made Indian manufacturing more and more noncompetitive. 

Misplaced government policies over the last few years where utilities setting up power capacities were allowed duty free imports despite huge domestic capacities being set up has led to a huge growth in Capital Goods imports. However this should ease off in the near term as the investment cycle has virtually come to a standstill. Coal is clearly one sector that needs a drastic overhaul. Coal India's production inefficiencies are costing the country precious foreign exchange reserves. However the GOVERNMENT trapped in Coalgate is unlikely to move on this front in the near term.

Gold consumption should stabilize as prices come down or remain stable. Overall my view on gold is strongly bearish and I believe that we could see another 20% coming off gold prices over the next few quarters. Crude imports are obviously a function of both prices and volume of imports. However it might not be wrong to say that the worst of the increase in deficit due to continuously rising crude oil prices might be behind us, at least for the next couple of years. 

Under the circumstances a focused approach on boosting exports is necessary. The labour cost advantage with China has grown over the last three years as salaries have moved up sharply in that country. Lower interest rates & reduction of transaction costs could be helpful in boosting exports of labor intensive products going forward.

In the near term we have seen significant FDI flow proposals into the country, however in already established companies like United Spirits, GSK Consumer, Jet Airways, Hindustan Unilever & now Bharti Airtel. This shows that India is still seen as attractive by the promoters of these companies and strategic investors. The same needs to happen for Greenfield projects or in Infrastructure companies. Obviously the mess that the entire infrastructure sector is in today requires action from the government and not anyone else. In the last cycle we did see large number of Infrastructure projects in the country attract a large amount of FDI. The same cycle needs to be restarted. In the roads sector NHAI had proposed more of annuity and funded projects to be awarded. However nothing has moved on that. Annuity projects should be able to attract strong FDI from private equity funds.

Time to move away from text book economics

It is high time that our policies move away from text book economics. It’s a very different world today where new economic & monetary policies are being written every day. Our policy makers need to adapt and adjust to the same. How ironical is it that the US markets are today at all time highs, mid cap companies in the US are also at all time highs & the economy seems to be on the bend. This is the country that started the financial crisis in 2008 REMEMBER. At a time of QE’s, OMT’s, money printing by the Bank of Japan etc we still seem to be responding in the same traditional way. In our urge to control risks what is forgotten is that if there is a bubble being formed in the US and we are trying to pre-emptively fight it, eventually when they go down we will also go down although we might not have moved up accordingly. Forward looking policies are necessary. For example the Bank of England kept on printing money and kept policy rates at 0.5% despite the inflation going up to as much as 3% as they saw higher inflation as a passing phenomenon. This seems to be playing out well for them now as the economy has stabilized & inflation has started coming down.

Tight monetary policy & its benefits have run their course in India. By cutting the Repo rate while keeping liquidity extremely tight the RBI has ensured that there is no transmission of the monetary policy. It’s important to get the transmission going today. RBI’s fears of a run on the rupee are totally unfounded. Infact the INR needs a growth boost. If India is perceived as an economy that is growing faster we will attract much more long term money. High interest rates will however ensure that this does not happen.

In conclusion I believe that the entire argument that monetary policy is constrained due to the high CAD is extremely fallacious and does not take into account the reasons for the high CAD. The record high CAD has occurred at a time of very high interest rates in the economy not otherwise as such how will continued high rates bring it down.

Its wrong diagnosis and wrong prescription.

REVISITING THE THESIS, ONE THIRD INTO THE YEAR

As the year started off, things looked optimistic in the global and Indian context based on several factors. In the Indian context the positivity was primarily based on expectations of a more proactive government on the ground and also an easing of inflationary pressures which would force the RBI to act. In the global context the positivity was based on easing concerns in Europe with regards to the sovereign crisis in the peripheral economies, the expected weakness of the Japanese Yen based on monetary easing in that country which would lead to positivity in the Japanese economy as well as the re-emergence of the Yen carry trade. The positive economic data coming out of the US combined with the relative attractiveness of equities versus bonds was also expected to be positive for equities globally.

In this context my expectation at the beginning of the year was that we should see new highs in several Western economies stock markets and a positive trend to build up in India & some other EM’s  too. As expected we have seen the US and European markets do well and a tear away rally in Japanese equities. Some EM’s have done well but a lot of larger EM’s have underperformed in this time frame.

In the Indian context the year started off well, however renewed concerns on inflation and government on ground action led to a loss of momentum in the months of February & March. Concerns on a high Current Account Deficit has also played on the minds of investors. Continued FPO’s by the government in order to meet its disinvestment targets at lower and lower prices also soured sentiments where incrementally investors lost money on every following FPO.

 However a rapid decline in global commodity prices over the last two months, which is something that was always imminent at a time of poor consumption and high prices has come as a very positive development for India. We have seen most global commodities correct 15-20% in this time frame, which combined with extremely poor demand conditions in the Indian economy has led to a virtual collapse in inflationary outlook where we have seen the WPI already fall below 6% in March and is likely to reach a level of 4.5% over the next two months. Why RBI is not able to see this move in inflation and why they are not bothered about economic growth is something only known to them at this stage.

The global scenario in terms of the stress on the credit markets has eased off significantly with both Italian & Spanish bonds seeing yields fall to pre crisis levels. This is something that is very positive in my view given that there has been a huge political crisis on in Italy with regards to the formation of a new government. The other big event has been the fall in precious metal prices where we have seen a huge sell off followed by some bounce back. However all indicators suggest that the bull phase seems to be over for these metals for a very long time. Infact the chart of gold price movement that we see now is very similar to that we saw in the mid 1980’s where the gold prices crashed by nearly 70% from the top. Lets see how it plays out this time, however we should see gold prices correct to atleast $ 1150 per ounce over the next few months. The first chart below is that of the mid 1970’s to 1983 and the second one is of the current gold move. As is always in the first crash of any asset class it is taken as a correction and people who were standing on the sidelines watching the upmove jump in to buy. This is apparent in gold now as physical consumption has picked up significantly over the last 10 days. However this upward correction is unlikely to sustain as gold demand supply dynamics clearly indicate that it has primarily been investment demand that has driven gold prices up. Gold consumption for jewelry peaked in 1997 at around 3300 tonnes, which today stands at just around 1800 tonnes. Overall consumption is almost the same driven by huge investment demand. As the trend gets broken we are likely to see investment demand fall off drastically taking the commodity into surplus. This downmove should ideally last a few years now.

GOLD 1970's-80's

 GOLD NOW

Bond yields of troubled European countries have come down to precrisis levels and the debate on austerity has reached a stage where it seems clear that continued austerity will not be politically palatable as the crisis has eased off.  The combination of these two combined with a much needed weakness in the Euro over the last three months should lead to some sort of recovery starting in the European economies over the next two quarters.

ITALY 10 YEAR BOND YIELDS

 SPANISH 10 YEAR BOND YIELDS

MARKET OUTLOOK

The market outlook is supported by strong macro turnaround indicators i.e falling inflation as well as an imminent decline in interest rates in the economy, all forecasts predicting a normal monsoon as well as a result season that has been quite reasonable till date. However on the contra side is the renewed political wrangling which are stressing the already subdued governance in the country. On ground performance of various promises of the government as well as the expectations from the Cabinet Committee on Investments has been below par till date. On top of that we have a sceanario where most developed markets have done very well YTD & there could be a corrective move in these markets at some stage.

In this context the action that the RBI takes in their next meeting is going to be very important. A focus on growth will push the Indian markets forward and we could see the reversal of the sharp underperformacne YTD. However inaction could see the markets go back into hibernation for some time again. The odds are in favour of a push towards growth. At this stage we are virtually flat YTD. A 15% return from here till End of the Year should still be possible. 

“Value Creation in India Over The Last Two Decades”.

Value Creation over the long term is always the facet of stock market investing. Most investors who have invested over the long run have made strong returns from their investments. The fall in markets since the stock market peak of 2007 has built a strong conviction in the minds of people that equity is a bad word and investment in equity should be avoided. However in reality in an economy like India where growth is likely to average 7% plus over the long term and demographics are so strong that the working population will keep on growing over the next three decades at least it is investing in Equity or Real Estate which will make inflation beating returns.

The decade of the 1990’s started off with the boom induced by the first round of economic reforms that were unleashed and the economy was opened up after the crisis in the early 1990’s. This lead to a huge spike in the stock markets which was largely driven by the unknown. At that stage various companies belonging to the core sectors like Cement, Steel, and Automobiles etc shot up before the boom peaked off in the year 1992. Post that the performance of the overall economy and markets was nothing to speak about till the advent of the new millennium. Economic growth remained modest and lot of companies that had over invested in capacities suffered a lot. However there was a set of companies that did create significant wealth for investors during that period. The first set of companies were the stocks that were the fancy of the 1990’s i.e. MNC stocks across the universe but specifically from the FMCG and Pharmaceutical sectors where due to the poor performance of the economy and virtually a total absence of any sort of investment cycle a large number of companies like Hindustan Lever, Colgate Palmolive, Glaxo Pharmaceuticals, Aventis etc gave very strong returns and their valuations continuously moved up.

In that time period there was another set of companies that emerged and became huge wealth creators. Both these set of companies leveraged the growth opportunities in Developed countries, specifically the US to grow rapidly. These were the Information Technology and Domestic Pharmaceutical companies. Cost cutting was the first reason which started outsourcing by companies from the US which lead to the emergence of companies like Infosys, TCS, Satyam, Wipro etc who leveraged the labour arbitrage at the initial stage before moving up the skill ladder slowly over the next several years. Investors who invested into these companies at an early stage made multibagger returns despite the huge crash in the year 2000 & 2001. Domestic Pharmaceutical companies took advantage of the low cost manufacturing and skilled manpower to start supplying generic products to the developed markets as medicines started going off patent.  This included companies like Ranbaxy, Dr Reddy’s Lab, and Sun Pharmaceuticals etc. This phenomenon has continued strongly even till date where Indian companies are now extremely strong in the global generic space, although many have tried and failed to actually come out with any new product. Both these sectors did well as they had high return ratios, high cash flow generation and no policy risks from the government. These companies continue to be wealth creators even now.

As the second round of economic reforms and investments started in 2002-03 another strong set of wealth creators emerged in the form of Public and Private sector banks. The initial rally was started by Public Sector Banks that were holding huge amount of government securities which created major capital gains for them as inflation fell and bonds rallied. New generation Private Sector Banks with their strong risk management, low political interference & focus on profitable growth have been wealth creators over the last decade. The boom of the year 2003-2007 created several winners, most of whom have not been able to create any long term return. The last decade has also seen home growth FMCG companies come up in a big way and companies like Asian Paints, Pidilite Industries, Dabur, Marico etc have been huge wealth creators with their high return ratios and strong cash generation.

Several companies from core sectors like Cement, Automobiles, and Telecom etc have also been strong wealth generators for long term investors, however due to cyclicality the returns from these sectors have come in waves and there have been periods of strong and weak returns. Wherever government interference or policies impact the growth of companies have seen periods of strong returns when policies have been supportive and extremely poor returns when policy has been a hindrance as has been the case over the last 5 years. There are companies that were the blue chips of yesteryear's who did not have a strategy for growth or shareholder value creation and have been waylaid over a period of time. On the other hand there are companies that have taken global competition head on, innovated products, acquired capabilities by acquisitions and have created shareholder wealth. This includes companies like Mahindra & Mahindra and Tata Motors.

The key to strong wealth creation over the long run seems to lie with generating strong cash flows, investing cautiously, walking away from unprofitable ventures, innovating products & services as well as recognizing risks. Strong managements who understand their business and have been able to either leverage domestic or global opportunities have been strong wealth generators. Given the demographics of our economy and the fact that global growth opportunities might be muted for several years going forward due to the Fiscal Correction required across the developed world, it is probable that the wealth creators of the next two decades might be those which are either domestic focused or acquire strong global market access through acquisition of capabilities via Mergers & Acquisitions on the global stage. However it is also true that in a vast majority of products and services the markets share of India is still very small and market share gains can still create huge growth in the global market place.

To conclude I would say that equity investing over long periods of time in a diversified basket of stocks will always create inflation beating returns.  Patience is the key.

DON’T BELIEVE THOSE WHO SAY

THE RUPEE WILL KEEP FALLING – Given the Current Account Deficit situation and the inability of exports to pick up despite the sharp underperformance of the INR against most competing currencies a theory is gaining ground these days that the INR is overvalued and it should fall more to make imports unattractive and exports more attractive. Keeping rates high has also been cited as a reason by RBI to keep rates high. Most of these are without basis. The facts are –

INR has fallen hugely against most competing currencies – If we look at the performance of the INR since the beginning of the year 2011 the currency has fallen nearly 22% against the USD. In the same time period the Chinese Yuan has appreciated 6%, Korean Won is flat, Thai Baht is up 3%, Indonesian Rupiah is down7% etc. Similar is the movement of most other EM currencies except for the Brazilian Real that has fallen almost as much as the INR. Under the circumstances it is difficult to argue that the INR is overvalued.  The reasons for poor export growth lie more in the issues that most exporters are facing due to the slowdown in the domestic market and high interest rates which are making Indian exports uncompetitive as they do not have the ability to provide cheap export credit at a time when most of the competing countries have record low interest rates. Moreover the reason also lies with higher imports due to one the inability of the domestic production to keep up with growing consumption specially in products like edible oils where imports are up from $2 billion to $ 10 billion plus over the last 3-4 years, Coal where imports are up from around $ 4 billion to over $ 12 billion and also due to mining ban on Iron Ore across the country where exports are potentially down by nearly $ 8-10 billion. The other two factors i.e. high gold and oil prices are well documented.

Under the circumstances while most people argue that the INR is going to fall going forward a combination of several factors actually point to the other side.

-Falling commodity prices are INR positive – As I wrote in a previous article the commodity cycle seems to have peaked out for at least medium term duration as of now. Falling commodity prices in Coal, Steel, Oil, Edible Oils, and GOLD etc are hugely positive for the INR as they reduce the government’s Fiscal Deficit as well as the country’s trade deficit. Fall in gold prices and reduced consumption by itself will reduce the CAD by nearly $ 10 billion this year.Infact Brent Crude prices are on the verge of breaking below the trend line that started from the March 2009 bottom.

­-inflation to fall big time – The sharp fall in global commodity prices and stability in food prices combined with the total lack of pricing power with domestic manufacturers is likely to lead to a sharp fall in headline inflation going forward. One is that this will reduce the inflation differential with the rest of the world and secondly it will push RBI towards growth both of which are INR positive.

­-fdi flows will eventually pick up as constraints ease – India is one of the largest economies where the FDI potential is most underutilized. This is due to poor governance as well as lack of policy clarity across a large number of sectors. However the reality is that the high nominal rates that Indian investments offer to investors are very high relative to any other competing economy. Elections are atmost a year away and either before that (hope) or after that (certainty) FDI gates will be opened up big time.  This will lead to strong flows into India at a time of abundant global liquidity. As such long term flow potential is also high.

Overall long term direction for the INR should be of appreciation not depreciation.

GOLD PRICES WILL KEEP ON FALLING - I called the peak of the current gold price appreciation cycle in my article on gold on the 19^th of December 2011. At that time and for the following one year after that this was a thought that was totally alien to most people.  However the reality is that when an asset class becomes the most fancied asset, when there are hedge funds that invest upto 85% of their assets in gold or gold linked products, when mutual funds instead of pushing equities that were extremely cheap at that time push gold, when hybrid products like triple advantage funds come up etc etc it clearly shows euphoria.  As such the peak of the gold cycle was very apparent to me. Now we are nearly 30% off the peaks and now we see that most analysts and commentators are coming out with reports to exit gold immediately.

The logic for further decline in gold prices still exists. Investment into gold and gold backed products is still very high with an amount of nearly $ 300 billion with these kinds of products. Besides this there are the uncounted assets of lot of hedge funds. Under the circumstances my view always was that first we will have long unwinding and then short buildup. So the key is to see what lies in store for precious metals.  If we go back into history precious metals had a period of nearly 15 years of sideways movement from the late 1980’s where the prices remained largely in a range. However that was also at time of high nominal interest rates and not so intense currency wars. Today we have a situation where nominal interest rates are very low with 10 year bonds of the US, Germany, Japan being at 1.7, 1.3 and 0.5% respectively.  Moreover instability in various economies still exists with the scope of black swan events still being there.

As such I do expect gold to correct more, maybe to the $1200-$1300 levels. However at that stage we could see interest again come back into gold from Sovereign Funds that are still overexposed to US Bonds.  Interest from other investors who have poured money into gold ETF’s as well as Hedge Funds however might not revive for some time. On the other hand we could see physical demand revive again as economic growth improves and incomes improve. Greater confidence, especially in a country like India will not only lead to more flow into risky assets but also into buying of gold.

What is clear at this stage is that Gold, silver and other precious metals have clearly peaked out for a long long time. However the theory that you just start recommending the direction of the move is clearly not right as risk free assets or low risk assets yield extremely low at this stage. As such another 15% down and gold & silver might be in the buy range again.

STAGFLATION BOGEY &INTEREST RATES DO NOT MATTER FOR ECONOMIC GROWTH – The kind of commentary that we see on India being in a stagflationary spiral is laughable at best. High policy rates have had a marginal impact on headline inflation as the drivers for inflation lie more in food price inflation and the correction in regulated power & fuel prices along with the INR depreciation of 2011. As the base impact of these wears off going forward inflation will come off.

Manufacturing inflation is below 4% at this stage, while food, fuel & power segment inflation are not linked to interest rates in any way. There is a total lack of pricing power in the economy today. There is no way that this is symptomatic of a stagflationary economy. Those who propound the theory of stagflation need to study their economics once again.

High rates not being responsible for economic slowdown is a theory propounded by lot of arm chair economist as well as the RBI. While it is true that the responsibility for the big downturn in domestic growth lies with the government due to their poor decision making across a wide spectrum of issues as well as the various scams that have spoilt the investment climate, it is also true that interest rates go a long way in deciding the viability of a project.  Why would Western Central banks and now the BOJ focus on driving long term interest rates down if it had no impact on economic growth.

The stress in a large number of projects that have already been awarded to various companies lies to a great extent on the environmental delays and policy uncertainty. It also lies in the inability of companies to fund the projects in a viable manner given the extremely low equity valuations, high debt on their balance sheets as well as high debt servicing costs. We have seen the market capitalization of a large number of infrastructure oriented companies come down to 5-10% if their peak valuations (not without reason) and also the debt on their balance sheets expand as some of them kept on expanding debt without thinking. However a lot of them also took debt as a bridge finance which was to be replaced by either equity in the company or project specific equity investment from PE companies or other investors.  With stock markets being in doldrums this did not fructify and the stress on the balance sheet grew.

RBI will of course take credit for the fall in inflation as it happens, however it is OK if they finally start focusing on growth. Inflation projection of the RBI will go wrong as usual, hopefully starting from today’s data that will come out later in the day.

Consumer demand in interest rate sensitive’s like Automobiles & Consumer Durables has also got impacted by tight liquidly and high rates. Negative car sales after 10 years are a testimony towards that.  

INVEST IN DEBT FUNDS – I find it ridiculous to see Mutual Funds putting out advertisements pushing Debt Funds these days. Till a year ago they were pushing gold products similarly. This is not the time for debt, but for risky assets as the macro indicators for the domestic economy have bottomed out and the huge fall in global commodity prices has improved Indian growth prospects hugely. As I wrote on my article on China and commodities earlier during the month the probability is very high that inflation will remain ranged for a prolonged period of time now. Under the circumstances I would like to remind investors of the fact that

 

“THE ACTUAL RISK OF INVESTING IN AN ASSET CLASS IS NORMALLY THE LOWEST WHEN THE PERCEPTION OF RISK IS THE HIGHEST”

Meeting with a large number of big investors over the last few days has indicated that a large amount of money is now going into pre booking of new real estate projects or real estate back interest rate instruments. The view that such prebooking investments will yield a return as the bookings open will again turn out to be a fallacy as project delays and lock ins make this extra return minimal or nothing.

A similar fancy was seen for structured products post 2008. In most of these products investors have been hugely disappointed as these products have matured after 3 to 5 years.

The two segments where investors should be ideally investing today are long term government of India bonds and Equities where we could be at the cusp of a big turnaround. Whether it will happen today or tomorrow is difficult to predict. However it will happen over the next two quarters for sure.

MARKETS

When I wrote on the market outlook the last time the view was for a possible 3-5% downside with a 15-20% upside subsequently. As macro developments have turned out subsequently this view has been further reinforced. Whereas risk aversion in the short run has created a scenario of foreign fund outflows, the longer term picture for inflation, interest rates and economic growth have actually improved. Volatility will continue for the duration of the results season, however downside risks have moderated significantly.  If the Cabinet Committee of Investments gets working to move projects on the ground over the next 1 or 2 months we could enter a virtuous cycle in India. In the absence of an actively working government the market moves will be much more slow and steady. 

MF Industry in India – THE “HAVES”, “CAN BE’s” and “THE HAVE NOT’s”

The MF Industry in India has gone through three distinct cycles. The first cycle started in the early 1990’s with the entry of PSU Bank floated MF’s into the industry that was just UTI at that stage. The initial phase of growth was very short where investors were largely unaware of what MF’s were and invested in Equity MF’s as if they were listed equities. There was hardly any investment education and no professional Fund Managers existed with funds in most PSU floated MF’s being largely managed by bankers on deputation to these AMC’s. The first wave of growth got hit by the economic downturn of the mid to late 1990’s.

At that stage there was the entry of private sector MF’s and professionalization in the MF industry on both the Fund Management and sales side grew. There was moderate growth till the TMT boom of 1999 where huge money flew into MF’s with expectations of exponential returns and most MF schemes that grew were also largely investing into these sectors. The subsequent crash saw investors lose a huge amount of money and total disinterest and apathy emerged towards Mutual Funds. This phase lasted till 2003.

As economic growth picked up in the year 2003 the stock markets started booming from mid 2003. The first phase of the rise was accompanied with total disbelief where investors continued to be on the sidelines or withdrew money as the markets rose. It was only after a new high was formed in the year 2004 when big money again started coming into Equity Mutual Funds. This phase lasted till 2008 by which time equity assets of MF’s excluding UTI jumped by nearly 10 times. At that stage equity assets became nearly 50% of overall Assets under Management. The subsequent fall in the markets and largely lacklustre markets over the last 5 year has seen the percentage of Equity Assets in the overall asset mix drop to below 30% as per the latest data available.

In this entire phase debt oriented MF’s continued to grow in size as this became a liquidity management instrument for corporate as well as a more tax efficient investment avenue for other investors who would hitherto only put money in Bank Fixed Deposits. Several Debt oriented schemes came about to cater to the needs of investors across the time horizon.

THE “HAVES”, “CAN BE’s” and “THE HAVE NOT’s”

As I look at the MF industry today I can see three distinct categories of Fund Houses.

•          The “HAVES” are those who have established themselves

•          The “CAN Bes” are those who have a proposition to sell and can become haves at some stage

•          The “HAVE NOTS” are those who will continue to languish with small asset bases

THE HAVES –

•          The haves are those who have established themselves with a long term track record, have a good brand perception with investors & are on an autopilot

•          These Fund houses also have a strong parentage & strong established Fund Management Teams

•          The haves will continue to grow due to the size of their assets which gives deep pockets, their strong presence and relationships with distributors, wealth managers etc

•          These fund houses also have the ability of attracting good talent

The Fund house in this category are HDFC MF, Reliance MF, ICICI Prudential Mf, SBI MF,Birla Sunlife MF, UTI MF, DSP BR MF & Franklin Templeton MF.

Over the last few years funds from this category have got most of the inflows

•          Over the last four years a bulk of Equity Flows have gone to HDFCMF, IDFCMF, ICICI Pru MF and DSPBR MF

•          The reasons have been different. HDFC & DSPBR have got money on the consistency platform

•          IDFC & ICICI Pru have got inflows on strong outperformance over peer group schemes

•          Other larger funds like Reliance, Birla SunLife & SBI along with a fund like Fidelity continued to get SIP flows while losing money on the other side

•          Besides this some smaller funds have also shown growth, largely driven by performance

THE CAN BE’s –

•          These are fund houses with strong parentage that gives a positive brand recall

•          Most of them have established themselves somewhat, and some are still small

•          The values of trust and durability are associated with the parent brands which can be translated to the MF

•          These are the next potential “Haves”

•          These Fund Houses are either part of large groups which have not focused on the MF or

•          Have not focused on building their Fund Management capabilities

•          Have had poor sales and marketing strategies which have not been consistent over time

•          The Mutual Funds that fall into this category are Tata MF, Kotak MF,IDFC MF, AXIS MF, L&T MF, LIC Nomura MF,Sundaram MF & BOB Pioneer MF.

THE HAVE NOT’s –

•          These are the remaining players that do not have a clear proposition to sell to the clients

•          In some of the cases the parentage might be strong but they do not have a clear India Strategy at this stage. E.g. JP Morgan, Goldman Sachs

•          Some like Religare, Deutsche, Canara Robeco & HSBC despite having good brands do not have a clear expansion strategy, they also have very small Fund Management teams; in some cases single FM teams

•          Most others are just there

Post the Lehman crisis investors into MF’s have largely taken a risk reduction strategy where they would rather reduce downside risk, unless and until a smaller Fund House has got a distinct proposition to sell. This move has further accelerated after the regulatory changes that have come in the MF industry subsequent to the end of the “Entry Load” era. In this phase where huge loads could be loaded on to the investors we saw an era of large number of NFO’s as well as hard selling of funds just for commissions by various kind of MF agents be it Banks, Wealth Management outfits or IFA’s. The sentiments for MF equity schemes has got further marred by the losses investors have suffered due to investments in mis-sold ULIP schemes where the charges on investors were so huge that they have lost a lot of money. However that’s not the main point of the article.

THE WAY FORWARD FOR “CAN BE’s”

•          These MF’s need to build strong  Debt and Equity teams to  inspire both investor and distributor confidence

•          Even Fund Houses that propound a “Process driven approach” are associated with strong Fund Managers, whose views are associated with that of the MF.  

•          After the end of the “Entry Load” era, fund houses with sustained & strong performance have grown and the rest have de-grown or stagnated.

•          In order to get back to the investors radar consistent long term performance is essential

•          Along with the performance, investors & advisors also need to know what will drive this performance & who they are investing with

•          The proposition being offered to investors needs to be clear

•          Historically MF’s that have seen strong growth have one or two core funds that are top notch performers

•          As the core funds do well, the performance of these funds leads to growth and flows into other schemes too. There are several examples of this in the MF industry.

•          A talented, stable & process driven team, who have a long term commitment can lead to this transformation

MF INDUSTRY FROM “PUSH” TO “PULL”

·         The MF industry was built around the “PUSH” platform in the era of high entry load

·         Funds that paid out high commissions got more inflows. Performance was important but not critical

·         After entry load ban the industry has become a “PULL” industry where fund performances are the most important criteria for inflows

·         AMC’s with strong all India presence, good brands & strong equity performances will continue to grow.

•          Sales teams of most MF’s which were used to pay out huge commissions to get inflows have been unable to adapt to the changing reality

•          Distributors who were earlier focused on transaction commissions, either have moved out or are transitioning to the “Wealth Creation” platform

•          Direct selling of the proposition, that a MF offers & working with Investment Advisors to get funds into the recommended category is the future

•          The proposition needs to be clear to the investors i.e. why should they invest with you and not the top 5 MF’s

•          Sales teams need to be either retrained in order to adapt to the current realty. Just distributing commissions is not going to lead to inflows

•          With the average investor life in an equity MF scheme being just around 18-20 months the payouts for getting assets has to be more back ended and profitability will have a huge operating leverage play. The older MF’s that are in the “HAVE’s” category have a much greater investor longevity as investors have made money with them over a period of time and are as such much better positioned.

•          The “Can Be’s” need to have an equity corpus of at least Rs 5,000 Cr in order to sustain a strong Fund Management and Marketing team and move into a phase of auto growth. This is because the fixed cost of building a successful Fund Management and all India Sales outfit should be in the region of Rs 30 Cr per annum.

So if once in HAVE’s does that mean always in Have’s

The main advantage of building an annuity Fund Management business is that although the climb up might be tough, once you have climbed it is also difficult to fall drastically. So what this essentially means is that once you are up there it will take time to be dislodged. This will largely happen if performances remain below par for a prolonged period of time. We have already started seeing this happen with one of the largest Fund Houses that has been floated by a large industrial house where the performance now is a flicker of the earlier top notch performances. This is also evident in the case of a prominent global Fund House promoted MF that operates from down south. However even in the case of these fund houses they continue to be significantly profitable due to legacy assets and the move down is also slow. However it does open up the opportunity of some other MF’s from the “Can Be’s” category to build a performance track record and move into the “Haves” category as the next wave of growth starts.

IN SUMMARY

In summary, as a keen observer of the MF industry it is very clear that the industry has gone through a strong phase of consolidation. Investors into MF’s and distributors have become cautious, which has made it difficult for smaller MF’s to grow. This has also been accompanied by regulatory changes that have made payouts for selling MF’s seeing a major reduction. Clear strategies and distinct propositions are necessary to be shown to investors for smaller MF’s to grow from here on.

However that said it is also very clear that markets and growth in an industry moves in a cycle. With the macro indicators for the economy clearly having bottomed out growth revival in the economy is imminent. As inflation and interest rates decline sharply over the next six months we will see the economy revival start, companies starting to report more profits and stock markets picking up. It is my strong belief that in a country like India investors will make inflation beating returns in Equities & Real Estate over the long run. Real Estate has become a favoured investment destination over the last three years as equities have underperformed. Relative valuations are now in favour of equities.

The last three market cycles have seen peak Price to Earnings ratio at 30-32X earnings. What goes up comes down; similarly what goes down also rises. The cycle always turns and it will turn this time too.