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.