After a 100% rally from the March bottoms the markets today look to be wanting to pause. The rally from the March bottoms has been fuelled by a variety of factors which includes an unprecedented flow of cheap money into the global monetary system, the bottoming out of economic performance and a sharp uptick in some countries like India ( Industrial Production up by 10.4% in August), China ( GDP up 8.9% in the last quarter) and stabilization in a number of other economies in the West with the downward spiral getting controlled. Infact inflow into emerging market funds have far exceeded the highs of 2007 and the week ended October 21st 2009 saw an inflow of nearly USD 4.4 billion.
While the initial upmove was fuelled by the avoidance of a Catastrophe the subsequent movements have also been driven by cheap money carry trades of the US Dollar and the Japanese Yen. Valuations that had troughed at around 9-10x earnings have now moved up and the Indian markets are trading at around 18-19x earnings. The BSE Sensex EPS for the current financial year is likely to be in the range of 950 and should move to a level of around 1150 for the financial year 2011.

The current results season has generally been one of positive surprises till date with a vast majority of companies from the Automobiles, Banking, Consumer Goods etc that have reported till date have done better than expectations. Capital good companies have been a mixed bag and a large number of mid cap companies have surprised on the positive, specially on the margins front. Low input prices and carry forward of low cost inventory has helped the cause. For the companies that have reported till date there has been an around 5% sales turnover increase and a 25% profit increase. Performance of commodity companies have been subdued, however are likely to pick up going forward. Pharmaceutical companies have also come out with good results.

The strong uptick in margins due to low input costs are unlikely to sustain as input prices which include most metals, oil, chemicals etc have moved up sharply. Although companies will have some pricing power in light of the improving economy the near record margins that most companies have reported for the current quarter are unlikely to sustain.

The telecom sector has taken a hit due to the intense competition and the investigations launched into Spectrum allocation recently should act as a dampener for the sector in the near term. Although there is not much to lose in these companies as far as valuations are concerned, negative news flow will weigh on the stock performances.

Taking all things into account I believe that we are now entering into a phase of the markets where the news flow as far as the performance of the economy is concerned will keep on improving and the overall momentum in the performance of the corporate sector will continue, however the markets will now need to take a pause and adjust the valuations for the move that has already taken place. As such markets with an underlying positive bias will in all probability remain in a range for a slightly prolonged period of time. Whereas the markets have moved up by nearly 100% over the last one year the next one year is unlikely to see a growth of more than 20% from the current levels.

Given the fundamental outlook on earnings I would say that the lower levels of the markets should be at around 12x 2011E earnings which comes to around 13500 for the BSE Sensex and the upper end could be around 20x 2011E earnings which comes to around 22000. The upper and lower bands in my view are extremes and unlikely to be actually seen over the next 12 months.

So under the circumstances the markets will become stock specific and there will be a huge potential to outperform by having the right portfolio mix. Whereas the last one year has been disastrous for active fund managers due to the momentum up move of the markets as well as the fact that any cash in the portfolio became a big drag ( for example a 10% average cash level in the market that goes up 100% drags performance by 10%). It was very difficult to outperform in the last one year. However going forward a few right picks in a range bound market can really make the portfolio outperform.

I am positive on sectors like automobiles, Oil and Gas and Financials on the large cap side. On the mid cap side of the market Sugar, Auto Ancillaries, construction companies as well as alternate energy companies offer opportunities.

The next one year will be where specific strategies by company managements will become important as the last one year was more of a macro period where initially the market meltdown hit companies in a manner where irrespective of the specific strengths of companies all went down and the last 6-8 months have seen a similar upswing. I personally like ranged markets much more than momentum markets as they do not give time for research and analysis. Companies with better growth strategies and high earnings growth would tend to get greater value in more ranged markets. There is a very high likelihood of a 15-20% correction in the first few months of 2010 and that should provide an excellent entry point for investors who have missed out the first wave. Typically correction in a bull market that we have entered now should not be more severe than this.

I do not think that the prediction of the extreme bulls that we will continue to move up with momentum is likely to fructify.

We are all wrong so many times that it often amazes me that we can have any conviction at all on the direction of things to come. But we must as in this business you are good if you are right six times out of ten. No one’s going to be right 9 times out of 10.”

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