Which way will the markets go – 2004 or 2008 ?

Over the last few days as the markets have corrected by over 10% in most parts of the world the question that is coming in everyone’s mind is about the likely extent of the current correction and the shape it will take. Frankly I missed out on the current correction as my outlook was to focus more on improving fundamentals in terms of economic growth and earnings growth prospects. However the fallout of the Greek crisis and the fact that there have been different noises coming out of Europe further accentuated the extent of the fear in the minds of investors leading to the markets selling off. The sell off in commodities has been much more severe given the fact that there have also been concerns on Chinese overheating and an expected slowdown in commodity consumption. Due to the sharp rally in commodity prices lot of idled capacities has either started producing again or have plans to do so. This has led to most commodities correcting by nearly 15-20% from the peaks. This has led to concerns on commodity oriented economies whose markets have corrected much more than commodity consumers.

The fear psychosis due to the fact that 2008 is still very fresh in the minds of investors has been so high that immediately comparisons have started with that year and expectations of a severe sell off have grown. Given the fact that a number of key markets along with commodities are today trading below their 200 DMA has also led to most technical chartists forecasting doom. However the fact of the matter is that in all major correction in bull markets 200 DMA’s are invariably breached for short periods of time. I do not really believe that this should be a major concern.
The fear in the minds of investors has also led to the volatility index VIX spike up sharply from a level of 15 a few weeks back to over 45 last week. This has happened on a correction of just around 10-12%. Incidently VIX has spiked above this level only a few times in history and leaving aside the 2008 crisis where it went much above 80 the other times when it has shot up this way has been during the Russian Financial Crisis, 9/11 bombings, LTCM fallout etc. This is a clear reflection of the fact that it is fear rather than greed which is the dominant psychology today. As such at the first instance of the fear of something going wrong most investors panic and want to withdraw.
The ironical thing also is that around a year back there were fears of Government bond yields shooting up due to excessive borrowings by governments all around and fears of increasing fiscal deficits. Although higher fiscal deficits are a reality today and the current market correction has been driven by Sovereign default risks led by the PIGS economies the borrowing costs for the governments of the countries first affected by the crisis, namely the US and UK continue to remain at extremely low levels. US 10 year bond yields are infact totally flat vis a vis last year at a yield of 3.2%. This is despite the prospects of the fiscal deficit getting extended over the next few years. The US Dollar which was supposed to be a doomed currency around 18 months back is again the currency of choice now.
Similarly Indian Govt 10 year bond yields are up from around 6.6% to 7.4% despite inflation above 9.5% and the start of the tightening process by the RBI around 6 months back.
The bigger fear in the minds of investors of a spiral in government bond yields has not materialized as the reality is that the risks of a sub par growth rate nearing 1% per annum and deflation due to high unemployment and low capacity utilizations is a bigger concern today in the developed world which still constitutes more than 65% of the world economy. Given the fiscal concerns of governments of these countries and strained balance sheets of households it is unlikely that there is going to be a big rebound in growth rates of these economies for some time to come. This is also reflected in the valuations of stocks in developed markets which trade in the range of 10-12X earnings. Chinese markets after the sell off they have seen over the past few months’ trade at around 16x earnings which is one of the lowest valuation of the last several years. This is also due to the fact that the market recognizes that China will not be able to grow at the rates at which it has in the past without the overheating of the kind we are seeing today and as such is discounting a lower long term growth rate for that country now.
Indian markets trade at around 15X current year earnings and 11.5-12 X one year forward which is not expensive given the expected growth rates of earnings.
By no yardstick do I think that the Sovereign debt crisis is nothing to be worried about. However this crisis is a vestige of the past crisis and is not a new one. The over borrowings of the last decade and the lack of will on building up the governments balance sheet in good times has led to this crisis. However given the fact that for most investors 2008 is still very fresh in the minds there still is no overleveraging in the investment in most asset classes. The allocation to risky assets has still not increased very substantially and the retail investor frenzy that is associated with a 2007 end or 2008 beginning kind of market is not even remotely visible. Most investors are not sanguine about growth prospects but are looking at risk around every corner. Investors are more willing to act on a sell recommendation rather than on a buy reco. As such positionally the market psychology does not point towards a big corrective move in the markets.
Interest rates are expected to remain lower for a longer period than earlier predicted due to reducing inflationary pressures and the postponement of tightening by Western central bankers due to the fresh crisis in Euro Zone. This will further boost growth prospects in countries like India where we need adequate liquidity and low interest rates for sustaining our high growth rate of 8-9%.
In the short run there are two scenarios that can play out

Scenario 1 – Given the extremely oversold position of the Euro and the extremely overbought position of the USD, the USD starts correcting over the next few days. This brings the risk aversion trade to an end and risky assets start moving up again. Under this scenario the current 10% correction of the markets should hold and we should see the markets trending up again. However in this scenario a lot of investors will again be of the view that it was a shallow correction and the kind of momentum that we require to move higher might not set up. Although equity markets are looking oversold, they are not looking extremely oversold so as to reflect an end of the corrective move. However in bull markets it is possible that sometimes we might have shallow corrections too. Under this scenario markets would settle at around 16200-16400 levels of the Sensex and around 4850-4900 levels of the Nifty.

Scenario 2 – Under scenario 2 the panic that has occurred due to the Greek crisis would also lead to some outflows from equity funds globally. This would lead to the correction getting aggravated and we fall by 15-18% from the top. Under this scenario we get the first major correction of the current bull market. This will bring in lot of money at the sidelines into the markets as investors again start seeing value. This is backed by reducing stress in the Euro Zone and clarity on the progress of the monsoons in India. This will help us get over the valuation overhang of the markets and we begin the upward journey. Under this correction the last 4-5% correction will be very fast and will get taken out very fast. This is the most desirable and likely scenario which could play out over the next couple of weeks. Prices of stocks that will be achieved in this correction might be the best bargains that we get this year. Under this scenario we could see the Sensex correcting to around 15500 levels and the Nifty to around 4650 levels. At these levels markets would be at a valuation of around 13.5X current year expected earnings and will be cheap given the growth prospects.
However my medium term outlook is as follows-
Unless and until we get a fresh global shock that is not predictable and foreseen at this point of time the second half of the financial year looks very well positioned with the possibility of a 20-25% upside in the markets over the next 6 to 7 months.
In conclusion I believe that we are still in a 2004 kind of scenario and there is not even a drop of similarity between the euphoric conditions of 2007-08. As such I would rather focus on long term ideas to buy which would play out over the next 3-4 years.

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