valuation

Bang : And now, for the aftermath….

Sanjeev

Sanjeev

Just last month, I dwelt extensively on the over-valuation building up in the main indices. Besides the details given in that article, there were other indicators, which were building up and visible to real-time trackers like this columnist, but could not be talked about because as they were happening, it was just opinion; but once it happened, it turns into fact.

Declaimer: This article was originally in February 2018, and some of the data points may be outdated

Understand Market

For one, remember what Adam Smith said a long time back, “Markets will so compose their affairs, as to rob most of the people of most of their money”. In spirit, it’s a beautiful quote and you would do well to keep it in mind for your future safety. Another good quote is: “The Market is a killing machine, a seesaw that’s going to go down when the maximum number of people are loaded onto one side of the consensus”.

Just a few days back, we were pretty sanguine that ‘nothing could go wrong’ and this bull run was, what, for the next 50 years (yes, I heard this on TV). Maybe he’s still right, it won’t turn into a bear market yet, but it sure doesn’t feel good to have listened to such talk, does it?!

At 27 times earnings, we had an Earnings Yield of around 3%, while Bonds are yielding 7.5%. The LTCG impost is toothless, because its very announcement may have set the top of the market for maybe 1-2 years. Thanks to the grandfathering clause, the government only collects the tax, if the market goes over an anyway expensive valuation. I think somebody (in government) even said that this was done to cool an overheated market.

The Modi government

If that’s what it was, my respect for this government (which was hovering above the danger mark) just went up quite a few notches. It was Greenspan who first said that it was impossible to locate a bubble until after the fact. That remark set the low watermark for financial governance, indicating a policeman who said it was impossible to anticipate, hence prevent a murder, so it was better to be engaged in the sale of pistols while waiting for the murders to happen. Compare it to the Modi government, which has located a bubble, and then deflated it, to protect the long-term internals of the market.

Anyway, this bubble was an obvious one. Not only were the aforesaid macro-fundamentals showing a persistent red, but the build-up of leverage had reached impossible proportions, and it was pretty easy to stay out of trouble on this one. Thrice, at 10300, 10700, and finally at 11000, the market internals had set themselves up for a decline, and every time, there was a wave of (coordinated?) buying that pushed the shorts up to the wall. Not an extraordinary number of bears capitulated if you judge the size and nature of the subsequent correction. So LTCG was just a trigger in which the government cooperated in bringing down an overheated market, to preserve the larger bull run……if this is true, it reeks of Modi. A man who will put the larger national interest above sectarian considerations and make unpopular decisions, even when he gets no applause for it.

What was surprising was the timing of the other larger bubble in the US. A small uptick in wage inflation, which many have been watching out for, saw a terror-stricken prognosis of an inflationary uptick, a big spike in inflationary expectations, and serious Fed action to douse an imaginary fire. A sudden spike in US bond yields has set the Earnings Yield target at some 6% (India’s is still at 3%), almost 50% above the 4% just now. That indicates a 33% decline in US indices, with all other things remaining the same. The accelerator was Janet Yellen’s last interview, saying the market was expensive (are you sure?!), if not in a bubble.

Crowds understand simple messages, so all this data that was pointing to the obvious was ignored, but a single, innocuous event (the LTCG announcement or Yellen’s interview) can be a cataclysmic earthquake that will bring down everything. The Indian bubble was built up by furious but coordinated buying that took out all the resistances, at which trader-shorts were built up. These shorts were stampeded by the continuous rise in Nifty levels (driven by an ever-narrower set of stocks, mostly those in the MSCI). This happened even as the mid-cap and small-cap indices tanked seriously, with a very smart ICICI even closing down their small-cap fund. The people who got battered in this were the short-sellers. Once they capitulated, the market would have turned on a whim (which was provided by the toothless LTCG provision).

There’s a tendency to blame some government action for anything bad that happens, and the Indian media is particularly adept at it. I say that this is just what a sensible government would do, deflate an ever-growing balloon so that it doesn’t burst later.

And now what? I think the market has made its top for perhaps this year. It can either go into a deep correction (up to 20%, around 9000), a proper bear market (which, as I pointed out in my last article, would be where the last bull market started), or a long-term correction’, where the market ranges from 10,000 to 11000 for more than a year or two. Thanks to whoever blew up the bull market (right now, I want to credit Mr. Jaitley), I’m going to bet on the time correction, not even the deep correction.

The Bear Market

How does one play this, and keep whatever is left of the profits from the last bear market? If you got into stocks at the end of the last bear market, you will keep much of the profits (metals and private banks, for example, have a long way to go yet). Keep these stocks and start selling on rallies the broader indices, till they reach sensible valuations. But what would that be?

Conservatively speaking, you could assume zero earnings growth and a 12% nominal growth rate of GDP, which would give you 15 times earnings, the long-term average valuation. The problem of overvaluation comes from analyst forecasts of 20% earnings growth, which the market has discounted 3 years’ forward. This is all exuberance, and so far, has no basis in reality. Manufacturing capacity utilization is still low, which restricts pricing power. As it crawls up, it will push up inflation too, so a stock-specific investing strategy might work, but a broad-based index-based view that expects all boats to lift with the tide will come to grief. You could say I am bearish the indices, but bullish on specific stocks and sectors.

How then does one value an index? You cannot put a number to these things, but can certainly point to the direction. The exuberance of analysts will temper somewhat and the cheerleading will be seen as such. All that long-term talk about big, round numbers, which looks over forecasts of inflation, earnings disappointments, and demands unlimited patience, is misleading the public into lemming-like behavior which must come to grief. The key is to watch out for those sectors that are seeing steady improvement in capacity utilization, hence pricing power. These sectors will lead the capex cycle, which will be preceded by sharp increases in earnings.

Overall, I’d say that the market is going nowhere for the next couple of years, in an era of rising bond yields. For retail investors who have resisted the temptation of chasing the top, it’s best to stay in Bank FDs. For die-hard traders, sell on rallies, and hold your nerves. You will survive only if you don’t over-trade, remember to buy insurance some 5% above your selling levels. Dull sectors/ stocks might still give value if you buy and forget. But don’t try to bottom-fish in this market and certainly, don’t buy an early-stage declining market. Keep a keen eye on the global markets, the Dollar should be bouncing back against major currencies, particularly the Re. That is a good investment theme if you know how to play it (but most people don’t). Buy gold as a surrogate for the Dollar, gold prices in Re will track the gains in the Dollar.

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