Panic at its peak and markets looking to climb the wall of worry

The last couple of months have been amazing in terms of the amount of negative news they have generated right from the slowdown of the US economy and the volatility due to delay in passage of the Debt limit to the actual US downgrade. This was followed by increased pressure on troubled Euro zone countries where the contagion effect has been difficult to control due to two factors; one being the magnitude of the problem and secondly being the nature of the beast that is EU which is heterogeneous, slow moving, electorate focused etc. On top of these two the domestic factors have been the turmoil in the government during and after the Anna Hazare movement and the refusal of inflation to come down despite continued and incessant RBI tightening.

This has led to a situation of extreme panic in the mind of investors which has manifested itself in the form of record outflows out of Equity Funds. As per an article that I read today the total withdrawals from US Equity funds since April 2011 have been nearly USD 72 billion and are almost equal in magnitude to the withdrawals in the months leading from Lehman to February 2009 after which the markets bottomed. Debt and Money market funds have also turned wary with a number of US based funds withdrawing from Europe and going into specific country bonds which has led to absurdly low yields in countries like the US, Germany, Britain, Switzerland etc. while the rates have gone up for most other countries. The extreme fear has also created a situation of dollar shortage in the markets which has led to most currencies (ex of the Yuan off course) falling sharply in value against the USD. The Indian rupee has depreciated by nearly 8% over the last 6 weeks.

GOLD

In the meantime there is a huge movement into investing in gold and other precious metals which has pushed the price of gold up to levels that are difficult to justify by any logic. Infact the movement in gold prices is very similar to that of the move in the Mid 1970s when gold prices moved up from USD 100 to USD 800 to the ounce. The current move of gold started at levels of around USD 250 and at levels of USD 2000 gold would be up by 8 times from the time of the start of the move. Given the extreme bullishness in gold I am tempted to call a top in this commodity, however I will resist from doing that at this stage. However gold should ultimately top out at levels of USD 2000-2200 on the upper side.

If we look at the Q2 2011 figures on gold consumption as released by the WGC gold demand fell 17% during this quarter to 919.8 Tonnes. Jewellery demand was up 6% to 442.5 T and Demand from exchange traded funds fell by 82% to 51.7 T.  Central bankers were major buyers at 69.4 T. Central bankers bought more gold in the first half than in the entire year of 2010. Although ETF demand fell the demand for coins and bars went up sharply and these are also used for investment. China and India comprise over 50% of gold demand.  Gold supply during this quarter was 1058.7 T. Gold imports into India went up by 60% to 267 T. Investment demand was up 78% to 108.5 T and jewellery 17% at 139.8T.

The kind of buying being seen in gold and the huge amounts that are going into investment demand have two parts to it. The first is a structural shift where investors would hold some gold as that has been the asset which has moved up for the last 11 years and the trend tends to be followed. The second is the buying due to fear, lack of faith in paper currencies, inflation etc. which are cyclical by their very nature and will reverse at some stage. Given that there isn’t any actual shortage of gold availability and that it is an asset class that is the most fancied at this point of time indicates that eventually over the next year or so as things stabilize we should see gold peaking out .

The US dollar also seems to be shaping up for a longer term up move against most global currencies and over the next one year we are likely to see levels of 81-83 for the US Dollar Index. This move should be accompanied by moderating global commodity prices and will incrementally be positive for the Indian markets as it will reduce inflationary pressures.

MARKETS

At the time of the US downgrade my view was that this event will not have a long term impact on the markets. However the combination of this with several other events and the risk of a Greek default, European bank concerns and concerns on the downgrade of countries like Italy and Spain has spooked the markets. Macroeconomic numbers also have been reflecting slowing growth all over. These factors have led to the severe sell off in the markets over the last 6 weeks.

The key is to see thing going forward. Most negatives now seem to have got discounted into the markets and as such it is likely that we have made a base for the year 2011. Given the fact that this has been accompanied by great fear and cash movement out of risky assets we should see a significant pull back rally fructifying over the next few days. However the key will be to see whether this pullback can get converted into a sustainable rally.

Technically also most global markets have made significant positive divergences which point towards a strong pull back rally.

As things stand now the markets do look cheap in terms of valuations, however it lacks triggers to take the markets up beyond 10-12% above current levels. The triggers for the same could be in the form of

-         A reduction in negative news flow from Europe and a perception in the minds of investors that some sort of short term solution has been found.

-         An improvement in macroeconomic numbers coming out of the US

-         Fall in domestic inflation and a perception of sustainability of the decline, which would in turn bring an end to the RBIs tightening cycle

-         A clear change in perception of government decision making which can lead to the investment cycle being revived

However as time correction plays out the markets are becoming more and more attractive for longer term investors as a large number of stocks are available at dirt cheap valuations. The key now is to buy into these stocks and hold on without bothering about short term volatility.