Although i hate to go back into the year 2007 in order to explain market behaviour as it exists today, i think it is inevitable as both scenario’s are full of excesses. In 2007 the excesses were on the upside and today they are on the downside.
The last quarter of 2007 was a period of unbridled optimism and euphoria. I still remember meeting a conglomerate based out of Gujarat who have got huge expansion plans in power, SEZ’s, trading etc. etc. in the beginning of the year 2008. The Finance head of that company was going on and on in the presentation about how they are going to transform from a company with just about Rs 500 of profits into that of Rs 8000 Cr of profits in just about 4-5 years and for that they will need to invest around Rs 40,000 crores. When i questioned him on the funding requirements for the same, he said funding was the least of their concerns and they were only bothered about execution. At the end of the meeting as i shook hands with him i said quote – “I hope that the bull market continues more for your sake than ours “. That was also the time when earnings did not matter ( they still do not today in a more perverse sense as most people have become excessively pessimistic ).
Valuations at the end of the year 2007 had gone to such excessive levels that for some of the large cap and mid cap companies it implied a consistent year on year growth requirement of 30% for a continuous period of 20-25 years. Interest rates were moving up and inflation was beginning to raise its head after a period of benign inflation for over 4 years. In fact a large number of expert commentators were of the view that inflation had been tamed for good. Unfortunately that was not the case and inflation subsequently went upto several year highs due to excessive speculation shifting from equities to commodities.
However the key point today is that where are we in the cycle and how do we behave going forward. I will not go back to depression eras for this but just concentrate on the psychology of the markets. For those of us who have been tracking the markets now for a long time there are two key events which determine whether we have passed the worst phase of the bear cycle and that things should be better going forward. The first is that there has to be a catastrophic event, which in the last cycle was the 9/11 incident in the United States and this time has been the collapse of Lehman Brothers ( surprise surprise again in the United States). The second is some sort of scam coming out which in the last cycle one could say was the Enron fiasco in the West and stock market scam of 2001 in India. In the current cycle it would be the virtual collapse of the financial system as we have known it for so many years in the Western countries and the Satyam Computers fiasco in India. These two events combined make investors totally scared and unwilling to look at equities or other risky assets as something to invest in. This also leads to a flight towards safety which has been reflected by the kind of investors money flows we have seen in US Government Treasury’s and bonds as well as gold.
However the key to note is that at this time period when a sufficient amount of time has passed from the peak of the last cycle ( which in the current cycle is now 15 months ) the time to move out of risky assets is virtually over and infact we have come to a time when it is time to actually start building a portfolio of risky assets. Today most equity markets are down 50-70% from their peaks and most commodities are also down similarly. A large number of mid cap stocks have fallen 90-95% from their peaks. This is a time to actually build up a quality portfolio of stocks of companies that have got a sound business model and are not excessively leveraged.
It is important today to distinguish between the macro and the micro. Since the macro global economic environment has become so challenging, even prudent and conservative companies with strong business models have got affected due to the severe risk averseness, lack of availability of credit and a total pull back of investment and consumer demand specially in the months of November and December 2008.
I believe that today we are in phase of time in the markets where the worst of economic growth has been seen by us the the last three to four months due to the severe liquidity crunch. Inflation and interest rates are coming down sharply which will first lead to a revival in consumer demand and then after a lag investment demand. Today we have companies trading in the markets at prices at which investors can buy out the companies from their own cash flows of just two to three years. We have passed the phase of severe margin contraction due to the huge increase in input prices and are actually likely to see margin improvements going forward. Most analysts have become excessively bearish on both economic growth and earning growth prospects and are projecting between -5 to +5 earnings growth next year. Earnings are likely to grow much better than this due to a combination of lower input costs, lower interest costs and lower duties due to the significant reduction in excise duties. A year back when analysts talked about projections of earnings for Sensex companies for the year 2009-2010 the figures being talked about were in the region of 1050 to 1100. Due to the extreme pessimism prevailing today these expectations have come down to between 825 to 850 and even at these earning expections the P/E of the market is in the region of 10 times earnings, which is one of the cheapest in the historic context ( the lowest could be around 8x).
I believe today we are passing through an undershooting phase where markets are trading much below intrinsic value and most analysts, commentators and investors are not willing to look beyond tomorrow. This is the phase where investing will actually make money. This is not to say that markets cannot decline further. Given the downward momentum and redemption pressures of global equity and hedge funds markets can go further below intrinsic value before jumping back. The next two to three months will also see one more uncertainty related to the elections get over in India.
This is the reverse of the phase of the markets which was seen between October 2007 and January 2008 where the BSE Sensex went up from 18000 to 22000 ( severe overshooting). Today the decline in the markets from 9000 to the current levels and maybe upto 7000 (severe undershooting). Like that was the best time to sell, this should be the best time to buy.
Net net through whatever i have written i just want to say that this is the golden period to invest into equity markets. Even at current depressed levels of the markets long term equity investments have made a return of 17% per annum in the Indian markets. I strongly believe investments in the current year ( specially the next 3-6 months ) can make upwards of 30% return per annum over the next five years.