The year till date & the future outlook

The year 2011 started off with lot of optimism given the recovery in December and a poll of brokerages put the BSE Sensex target at 22500-25000 by the end of the year. However as soon as the year started the markets started getting impacted by negative news flow. First it was the spiraling food inflation where we saw the prices of several food products shoot up in a very short period of time. However due to a good crop and administrative measures food inflation which almost touched 20% has now come down to around 10% and likely to fall off sharply to around 5% over the next two months due to a strong base affect of last year as well as a general cooling off of prices.

Also continuing from the first round of 2G scandal and sell off in the broader markets due to a series of smaller scams the entire issue of the Telecom scam blew up in the face with accusations all around and continued speculation on the involvement of some corporate or the other. This also created a sense of discomfort among investors and India was one of the worst performing markets in January 2011 and also over the last six months now. While this issue was continuing we first got the Egypt crisis and now the Libyan crisis which has led to a 25% spike in crude oil prices over the last one month.

In between there were fears of aggressive tightening by the RBI in order to control inflation and severe liquidity issues and these created fears of a sharper slowdown in the economy?

Amongst all of this was the Union Budget where not much was expected and on an overall basis it was a positive one for the markets with expenditure control (credibility??) and a lower fiscal deficit being the main takeaways. Prior to the budget there was lot of talk about measures to boost FDI, however not much of this was talked about in the Budget and one has to see how this will be followed up in the future.

Over the last couple of days we have had some emergence of political instability due to issues between the Congress and DMK.

Amidst all of this the markets are down by nearly 10% since the beginning of the year and the forecasts for the markets from extreme optimism at the beginning of the year have now become a best case scenario of 19000 for the Sensex and around 5700 for the Nifty. We have also seen Emerging market funds lose around USD 21 billion since the beginning of the year as against an inflow of around USD 90 billion plus last year. Developed market equities have seen strong inflows in the same time frame. As such we today are in a situation where the fancied markets of last year have underperformed and the one which were perceived to have insurmountable problems i.e. USA (unemployment, jobless recovery, slow recovery, housing crisis etc etc.) & Western Europe (Euro breakdown, PIGS, Euro zone, Budget and Fiscal issues etc etc.) have actually done much better than most emerging markets. Infact from November till date the Indian markets have underperformed the US markets by nearly 20%.

The key is to see what lies ahead. One thing is very clear in my mind and that is that emerging economies are still going to grow much faster than the developed world over the next five years. Last year the growth in India’s nominal GDP has been 20% and it was just around 4% for the US and around the same for countries like UK, Germany, and France etc. The projection for the current year is also for a 14-15% nominal GDP growth. The GDP should touch a size of Rs 90 Lakh crores this year which is a size of USD 2 trillion. The current market capitalization is around USD 1.4 trillion and as such the Market cap to GDP stands at 80%. At the peak of the last bull market this had crossed well over 150% of GDP. As such the growth in the economy has been much faster than the growth in the stock markets where markets are still 20% off their January 2008 highs after three years of strong growth in the Indian economy. At a 14-15% nominal GDP growth the economy in INR terms will double over the next five years. The world Market cap to GDP ratio stands at around 90% and given India’s strong growth prospects on a steady state long term basis the Market cap to GDP should cross the 100% level and in times of Euphoria will again go back to the 150% level again. All these figures imply the probability of strong returns from Indian markets over the next five years and a 100% Mcap to GDP after five years would require the value rising to USD 4 trillion and a return of 23% per annum over the next five years.

One of the major reasons for the emerging market underperformance over the last six months has been the play against inflation facing economies. However the fact of the matter is that this threat is generic now and most developed world countries are also facing this threat. The genesis of inflation is largely the ultra loose monetary policies of the US Fed and ECB. However it will be very difficult for them to continue the same measures till too far in the future. ECB is already talking of rate hikes and the US Fed will also be forced into it over the next six months. The Chinese after relaxing and not acting for a very long time have now woken up to the threat of uncontrolled inflation and the social unrest it can bring in that country and have started tightening aggressively. As such I believe that this trade against fast growing emerging economies is likely to come to an end sooner than later.

The weight age of Crude related fuel in the Indian Wholesale price index stands at over 10%. However the actual consumption in the current year assuming a USD 100 per barrel prices would be in the region of Rs 5 lakh crores which is 6% of next years GDP. Moreover the rates of public transport like buses, railways etc have been largely stable over the last two to three years and private transport by cars, bikes etc is still a small part of the overall spend by Indians. As such whether fuel prices should be given so much weight age in policy making is also something to debate.

Valuations of the Indian markets have now come to around 14.5-15x 2012 earnings for the large cap indices and more near 10x earnings for the mid caps and look very attractive given the growth prospects. Economic growth continues to be strong and Services and Agriculture segments are doing well and consumption demand continues to be strong. The only near term risk (besides high crude prices) seems to be the lack of new project awards from the government and PSUs given the series of scandals over the last six months and it seems that there is a fear psychosis playing out. The government needs to move fast to correct this and restart the investment cycle which is showing signs of a slowdown.

On an overall basis given the extreme fear in the minds of investors, huge speculation in commodities specially gold and silver and the fact that most of the negative news seems to have been factored in now I am quite bullish on the markets. Infact I was mentioning to a friend my mine that these days most people do not ask me what stocks to buy but whether we should buy silver at current levels. This is not the time to buy heavily overbought commodities but reasonably priced equities. The time to buy into the markets is now and over the next few days and not one year later when all things will look benign and markets will be much higher. I am targeting a 30% returns from the markets over the next 12 months with the Sensex target at 25000 and Nifty at around 7100.

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