Que Sera Sera The Future’s Not Ours To See



The Nifty is some 27 times trailing earnings (don’t listen to Forward earnings, which seem to be forecasted linearly). We already have a sense that the projected earnings growth of 20% is not going to meet expectations for even the first year, let alone the 3 years of compounded 20% growth that is built into expectations just now.

Declaimer: This article was originally in January 2018, and some of the data points may be outdated

Here’s how the arithmetic goes:

So, at 27 times trailing earnings, Re.100 of current earnings (last 4 quarters) is available at Rs.2700.

Now the long-term valuation of a steady market is that it should be valued at the nominal rate of growth (of the economy). This is on the steady state (equilibrium) assumption that corporate profits as a percentage of GDP will stay the same. This ignores the cyclicality of corporate profits (as a percentage of GDP), which follow the waxing and waning of capacity utilization, the stage of the Capex cycles (i.e. leveraging or deleveraging).

Without going into the details of the various scenarios, let’s say that the nominal growth of the Indian economy is 7% (real growth) + 5% inflation) = 12% nominal growth. With some small increases coming from the tightening Capacity Utilisation, you can assume that the existing 3% of GDP that corporates earn, will go up somewhat, hence you can expect earnings growth of 15% over the foreseeable future.

Frankly, that is what the markets seem to have said on average, for a very long time. So for these markets to be valued reasonably, earnings must rise 80%, i.e. 2700/15 = 180, against the indexed base earnings of 100, which comes to 80%. That’s a CARG of 20% for the next 3 years.

This may be a fair assumption in certain cyclical plays

This may be a fair assumption in certain cyclical plays (metals, maybe industrials, for example), but I can’t see it happening in, let’s say, IT or Banking, which are seeing 1% revenue growth and 5-6% credit growth respectively. If these expectations are belied, where should the markets be? The most conservative estimate would be 12% growth @ 15 times earnings, an indexed value of 1680 compared to the current 2700 (which is 62.22%), close to the Fibonacci bottom (61%) of a bear market, if it were to start today. That means, for those who can’t follow this train of thought, that the market is worth 7200, about 62.22% of the current Nifty of 10,800. That’s close to the last bear market bottom. The actual bear market bottom may be slightly higher, because actual earnings growth may come in a little higher than my conservative 12%, and some patient holders may be discounting 2 years of forward growth. In a hardening interest rate environment, I can’t see it getting better than that.

This is also just when the Interest Rate cycle has definitively turned. Inflation is up, from the ‘Death of Inflation’ projections of 1-2% to an out-of-the-comfort -zone of 5-6%, warranting at least a small hike to communicate the turn of events to the market.

Worldwide, the Negative Interest Rate Policy (NIRP) regimes are ending everywhere, which is going to harden the cost of capital somewhat. The hardening may not be painful, or steep enough to trigger material deleveraging, but it should stop the frenzied bull markets worldwide. The Bitcoin (and other cryptocurrency) blowouts prove that sanity will return to pricing in money markets. Nothing about mass human behavior is ever orderly, but this might be the year when some of us will start using our logical brains.

the turn of the Interest Rate Cycle

I can’t believe that crowds can process events (the turn of the Interest Rate cycle) so quickly after they have happened, so maybe this fact is in the process of getting absorbed into markets. I have been telling everyone to leave equities and start building hedges in currency/commodities (like gold/silver), waiting for the lemmings to run off the cliff. The actual top may be some months away (Disclaimer: through my writing years, I have been consistently wrong in my timing, sometimes by up to 2-3 years. Mostly, it is because I see things, and talk about them, too early. From the first kid who says that the King has no clothes, to the time that the whole crowd is saying it, the process can sometimes take quite a few months. Just don’t try to time this).

‘Markets can be irrational longer than you can stay solvent’, so don’t take any naked positions that are looking for a crash. But hedged positions, like buying Dollars against a Bond portfolio would be a good way to short the market.

Does that mean that you should be selling everything and putting your money under a mattress? Well, new money, perhaps yes, but large chunks of the market are a Hold, but not a Sell. Will it be orderly? No, because I don’t like how people have become sanguine that they can’t see the end of the bull market (who can?), but they can see a correction.

Gold is a good place to hide. So is currency, bet on a reversal in the DXY Index, and some moderate Dollar strength, but don’t bet on a reversal in the Euro/ Pound, which will stabilize somewhere here. The obvious place to hide is short-term Bonds or Bank FDs.

A possible scenario is that there is no material price decline, but a long ‘time correction’, which exhausts any but the most patient long-term investors. Don’t make the mistake of counting on domestic flows to shore up the exit of foreign money, that’s for sure. The rise in Capacity Utilisation and some moderate pick-up in private Investment Demand might be 2 jokers in the pack, which might give some uptick to our assumptions of actual earnings growth taken above. This will be patchy, affecting some sectors more than others. It won’t be enough to shore up the entire market and the major indices.

So what does the ordinary, lazy investor do? In the genuine, long-term compounders, they should Hold. Companies with EVs of 6-10 times EBITDA, and low to moderate debt, should be held. Anything above that should be exited. If the ROCE is 15%, you should be willing to pay about 1.25 times Book, and then push up your willing-to-pay price proportionately. If you apply these mathematical filters, you should be able to weed out the most expensive segments of the market.

Lastly, the ‘Warren Buffet Ratio” of Market Cap to GDP is also in the danger zone. If cyclical profits as a percentage of GDP double, the current valuations will hold. That would require some tightening of the demand-supply balance. Given the low credit growth, any real growth in demand will add to pricing power in the corporate sector, but so would you see an impact on manufacturing inflation, which could bring an immediate impact on monetary policy. Those sectors with a material slack in Capacity Utilisation might see an uptick in their fortunes, so some stock-specific stories will see a big change. However the composition of the market is skewed in favor of financials and defensives, so it will not be a secular spread of wealth across the market.

If Inflation is the one constant in all the scenarios, it makes sense to buy that. In the short run, it makes sense to stick with short-duration bonds or simple FDs. And in the long run, to shift to long-duration Bonds, once real interest rates shift downwards (i.e. the spike in inflation out-strips the actual increase in Bond yields). Specific stocks that give you an Earnings Yield above the Bond Yield should be held. That’s a pretty large part of the market.



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