WHEN BAD IS GOOD, WORSE IS BETTER

As I sit to write today we are in the midst of a massive, which can only be said to be a “Meltup” in contrast to the “Meltdown” observed in March 2020 in most asset classes be it equities, commodities, cryptocurrencies etc. The move is driven by the belief that free money and money printing by Central Banks will continue forever and as such there is no risk to the downside. In the Indian context we have seen Foreign Investor Flows of Rs 3000-5000 Crores every day on an average continuously for the last several weeks. This is unprecedented and was not even seen at the peak of euphoria in 2007. So, what lies ahead.

Bad news is considered to be good as it implies more and more stimulus and money printing. For example, the US Markets rallied last week as job growth was much lower than forecast and consumer confidence came down substantially while COVID-19 cases continued to balloon with record infections and deaths on Thursday. Normally from a conventional analysis tool point this should be taken negatively. However, in the new world bad data is just another indication of extended Ultra Loose monetary policies and as such BUY risky assets.

Obviously its not all bad. The recovery from the bottom driven by low interest rates and fiscal boost in many countries has been faster than expected. Many companies have cut costs substantially which helped them boost profits much beyond analyst expectations even though top line growth was subdued. Due to work from home and need of personal mobility at the time of COVID-19 we have seen a much faster recovery in consumer durables including white goods, brown goods, household improvement products, 2-Wheeler sales etc. Many home improvement product categories have also bounced back substantially.

Stock Markets always react disproportionately to good and bad news. As such bad news normally has a sort of leveraged impact on stock markets where markets undershoot fair value substantially thus giving value investors an opportunity to buy. The reverse happens in a cycle of good news when again valuations become irrelevant as stocks move up continuously. The current cycle also has been driven by the good news of companies coming back to higher profitability faster and most companies are talking of back to “Pre COVID-19” levels. However, the challenge is to go substantially above those levels which is required for stocks to continue to trend higher. The Vaccine news over the last few weeks has also contributed substantially to the continued-up move.

The other big assumption globally is that inflation is going to remain subdued forever. Now for a country like the USA which has the reserve currency of the world if ultraloose monetary policy is not going to lead to inflation then the US Fed can keep on printing money and funding the US Government deficits without this impacting the market yields and interest rates. This is even better than Goldilocks as government gets to borrow cheap, the consumers get to borrow cheap, governments can spend what they want and still interest rates remain low.

However, it’s not as simple as US policies are leading to a debasement of the US Dollar which has been falling continuously. A lack of faith in the USD is the primary reason for the kind of euphoric rises we are seeing in Cryptocurrencies. This will ultimately come back to haunt the US as global central banks see lesser reason to buy US Treasuries over the long run. We have already seen the free money now starting to flow into commodities in a big way

Copper is at a 7-year high

Aluminium is almost at a decadal high

Steel Prices are reaching all time high levels

Agricultural commodities are on an upswing

Brent Crude prices although still subdued relative to historic prices have rallied 35% plus over last one month

As such the entire tenet of continuous money printing and keeping ultra low interest rates could get challenged next year. An inflation spike with still tenuous growth recovery will be very tough to handle as reversing the current ultra loose monetary policy is not going to be easy. The usual theory is that if unemployment is high then inflation will not come back as pressure on wages will not be there. Also with capacity utilization low producers of products will not be able to increase prices. However this could get challenged at some stage as when underlying commodities rally 30-50% final product prices will ultimately move up.

In the Indian context we have seen a strong recovery from the bottom in terms of the economy. Monetary policies combined with many people using their savings to come out of tough times has been a big contributor along with rural economy recovery. However inflationary trends are picking up strongly and there has been no real fiscal stimulus. Even in this background the Monetary Policy Committee last week vowed to keep rates down at least over the next six months. I expect that there will be a recovery cycle for sure with some sectors doing very well and others remaining subdued in 2021. COVID-19 getting under control, vaccines, return to normalcy will boost the economy on the upside however inflationary challenges will be key to monitor.

Some sectors like the real estate sector is just starting to recovery after years of subdued growth and prices. Residential real estate stocks might play out well so might many home improvement companies. Beaten down entertainment, hospitality, luggage etc stocks will come back strongly as once normalcy returns “Revenge” spending will come back in a bigger way. However this will also slow down growth in some categories where consumers have spent big time this month as they were largely at home.

Now coming to the stock markets. I will accept that the up move has been way beyond my expectations. As I write the Nifty has gone up 1700 points i.e. 15% without any correction. As I look at graphs of various markets globally I see a straight line up (a reversal of straight line down of March) which is not sustainable and even healthy for long term investors as the hot money flow is very high today. There are extremely expensive and over owned sectors and then there are cheap under owned sectors. Such times are good to sell out stocks which on valuations and growth prospects do not offer much upside and look to get into others where most investors are not looking to invest into. The current earnings growth estimates for next year for the Nifty are running at around 30% which is very high and possibility of disappointment is greater than positive surprises, a reversal of this year. Decade high margins driven by severe cost controls will not sustain going forward.

NIFTY now trades at a 27.5X earnings on historical earnings which is highest in over 10 years. However due to aggressive earnings projections it trades at 22X forward earnings. In this context the probability that the overall market returns will be subdued over the next one year is higher than the possibility of high returns. The good part about investing in a recovering economy however is that stock specific opportunities will actually increase and that is what we need to capture.

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