A Candle In The Wind : Looking For Diamonds In The Debris



So where were you when the lights went out? If you were consorting with Realty, Infrastructure, Banking & Construction, then please inflation accept my sympathies. The Rupee surprised everyone, and I don’t find anyone feeling rich these days.

Declaimer: This article written was originally in July 2008, and some of the data points may be outdated.

As usual, I will try and be the contrarian and go against the prevailing sentiment. Let us pick up one thing at a time.

The last market drop started with a huge uptick in inflation

The last market drop started with a huge uptick in inflation. That is the present, but markets are supposed to anticipate the future. If you just react to the present, you won’t make money.

The US has been the great supplier of global inflation, and it is already in slowdown mode, did you notice? The US money supply comes from two sources: the Fed and credit creation from commercial banks. While the Fed has just slowed down, credit creation by the commercial banks has collapsed, with massive deleveraging of bank Balance Sheets and drying up of risk appetite.

The third source of global inflation was the US Current Account deficit. This too, has changed composition. Earlier, the deficit used to reflate non-oil producers, principally in Asia; now nearly half the deficit goes to the oil producers. If oil comes down, the Current Account deficit could drop to 4% of GDP. More important, the resulting slack is unlikely to go back to personal consumption. This will strengthen the dollar.

Can you see how the Dollar will come back? I won’t even talk about how the long-term plans for alternate energy (geo-thermal, bio-fuels, etc) will cut into the Current Account deficit, reducing the supply of Dollars sloshing around in Central Banks around the world.

The point I am trying to make is: don’t be scared of the headlines, they only reflect current reality. Inflation is not as much of a bugbear as is made out to be. Food prices are already under pressure on the back of a good monsoon. If oil comes off even a little, we could see a surprising drop in inflation. Even without that, the current inflationary burst does not look sustainable.

Never before have the markets dropped so fast, so far. Even the IT bubble took 18 months to deflate 50%, this time the Indian markets have deflated 40% in 6 months. It does look excessive, especially when seen in the context of continuously rising tax collections, no slowdown in personal consumption, and a fairly benign growth environment.

No doubt, the build-up of exuberance in some specific stocks and sectors was excessive; those are the sectors that have got very badly damaged. But sectors like IT, where expectations were reasonable, have outperformed; they might lead the next rally.

Look out for ‘bear market rallies’, small sectoral upticks that come from the excessive beating down of stocks in an across-the-board bout of selling. I would bet on cement, which seems to suffer from misplaced fears. Companies are still running at over 100% capacity utilization, and demand from infrastructure and real estate projects is locked in. Yes, there are input price increases but they will be passed on, the moment inflation slows down. It certainly does not warrant the sharp marking down of the sector.

Now to oil, the biggest inflationary bugbear of all

Now to oil, the biggest inflationary bugbear of all. While I don’t want to be in denial, and I have to acknowledge the long-term supply shortages, the technical patterns do look like the precursor to a blowout building up in oil: excess volatility, scare-mongering, et al. This is just what happened in Nickel, which they said was the ‘next gold’, and look at it now: prices are down by up to 60%.

If oil comes off, the Indian markets will move up very sharply. Even if oil does not come off, at 13 times earnings, the markets look cheap now. Assuming that nominal growth in GDP will stay at 15%, the drop in real growth being made up by the uptick in inflation, we can expect the Sensex to show earnings growth of 20%, a P-E-G of 0.67.

Look back at Infosys, which fell to 1400 on EPS projections of Rs. 92 per share. Barely a quarter later, topline growth of 30% is being talked about. If we assume that earnings growth will follow, that means that the stock was then available at a 1-year forward P-E of 12 times or a P-E-G of 0.4. Infosys is up 30% since then. If I project the same logic, I could argue that the market will stabilize 15% above current levels, around 15000- 16000.  That would mean that some sectors which surprise, could go up 30-40%.

One little warning. From a look at the technical charts, it is still not clear that this is a definitive bear market; I am particularly suspicious of the speed with which the market has corrected and immature investors are shaken out. The market has corrected to its “Fibonacci Bottom” in just 2 spikes, which is a little unusual. If it now turns out that the slowdown in earnings was marginal (or non-existent), inflation was a temporary red herring and oil does not go to $200 (which it won’t if Asian demand slows down in response to high prices), then I would hazard a guess that Indian markets are actually cheap.

If oil comes off rather quickly, India will be one of the big take-offs and you will not get much chance to get back onto the stocks you sold. If this is just an intermediate stop in a long-term bull market, then we could quickly see the market return to the aggressive valuations that we saw last year.

No, this is not to suggest that the earlier bubbles in real estate, infrastructure, and banking were not real. This is merely to point out that in the resulting mayhem, a lot of ‘innocents’ have got decimated, which makes them attractive picks for long-term investors.

So now let us summarise the good news waiting to be discounted. American banks are a chastened lot and will be nursing their wounds for some time now. That should put a lid on credit creation and inflationary pressures. The Current Account deficit should be corrected somewhat; on a marginal basis, the absence of bad news on that front should count as good news.

India has traditionally had Money Supply growing at 15%, but this year, that has gone to 20% because of the build-up of Forex reserves. This is stoking inflation in the country. During an election year, I do not expect this to continue.

India is one special case where our Fx reserves are not owned, they are borrowed. That leaves India exposed to the risk of a steep currency devaluation if the Dollar reverses and starts appreciating. This could be one key risk to the optimistic scenario I have tried to paint above. A sudden spike in oil prices could widen the trade deficit, leading to a currency crisis. That would be 1991 once again. Then of course, the markets would be the wrong place to be in.



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