Sorry bears it’s a long winter

Over the last few days we have seen significant market weakness (contrary to my expectations) largely driven by rate hike fears and inflation. This has found support from renewed concerns on the sovereign debt of Euro zone countries that are likely to face refinancing issues during the current year. I have also come across some reports that are either calling the Indian equity markets a bubble or calling for a reversal in the bull market and saying that now this is a bear market as some trend line has got broken in the short run. However in my view what we are seeing in the markets is nothing but a bull market correction which happens every now and then. The bull market is very much alive and the key indicators of a long term topping out are totally missing as I will elaborate below.

No Euphoria – There has been no euphoria surrounding the up move and most retail investors have been on the sidelines with Mutual Funds and Insurance companies either have low flows or outflows. The retail participation in the secondary market has also been extremely muted. There have been more concerns being talked about rather than reasons for the markets to move up. I remember that in January 2008 prior to the market topping out no one could figure out any reason for the markets to correct or reverse. Every one and anyone’s grandma had become a stock analyst and retail investors were pouring in money into the markets as if there is going to be no tomorrow. As against that this time most people have been circumspect and have been arguing against a market up move rather than a continuation of the up move.

Extremely low leveraged positions – As a follow on of the euphoria that accompanies a long term market top there is huge leveraged trading specially on the stock futures side where most investors believe that markets will go up every day and as such try to deploy as much of their assets as possible into the stock markets. As against an almost Rs 90000 to 100000 Crores position in stock futures in January 2008 today the position in stock futures is just around Rs 35000 crores with most of the positions being in Nifty options. In fact the overall F & O position is that of low leverage rather than high leverage. With the overall leverage being so low it is difficult for the markets to crack very badly.

Valuations are middling, nowhere near are those of market tops – the overall valuations of the markets middling and at long term averages rather than at a 60-80% premium to the average that is there at the end of a bull phase. At the current earnings consensus the NIFTY and SENSEX are trading at a forward P/E of around 15X. At the end of the last bull market this level stood at 23-25X based on optimistic earning forecasts for the forthcoming year. However earnings projections are reasonable for the next year and most analysts have already downgraded their estimates somewhat taking into account higher input and interest costs. The current market valuations are in line with the first phase of a bull market and as the markets correct and rise further over the next few years we will see the overall valuations move up.

Mid caps are extremely cheap – The euphoric rise in mid caps that precedes a market top has been totally missing this time. Typically at the end of a long term bull market we see that mid cap valuations go above that of large caps. Investors totally start ignoring quality and the premium that needs to be given to established and good management businesses. However on the contrary the valuations of mid caps are at a 30-40% discount to large caps at this stage and in terms of ownership also investors have played safe and have focused on defensives rather than high beta plays. The mid cap universe is available at around or lower than 10X P/E at this stage which was above 20X at the end of the last bull market.

Everyone seems to know why the markets should go down – This is also extremely important psychologically for a market as at the end of the last bull market even when I was concerned on the way the markets were moving up no one seemed to be bothered about high crude prices, rising inflation, extremely high P/E ratios etc. Everyone was just betting on the fact that the fund flow will be extremely strong and that will drive the markets higher. Infact on today’s date the same people who were talking of record inflows this year are saying that flows might not be very good due to XYZ reasons. There is no surprise element per say and the concerns in the minds of everyone seem to be the same. Typically this is a sign of continuation of the trend rather than a reversal of the same.

Is the political risk real – I also agree to the fact that in India today there is a political risk element with all the issues going around. However I believe that the political risk is a zero/one event. If the view is that the government will not survive then the risk is real, however if the view is that despite everything the government will survive and last its term or at least much longer than this risk is not very real. There are also concerns on a total lack of policy making over the last few weeks. This is something that could have an impact on the long term growth prospects of the economy.

On an overall basis after evaluating all the above factors I do not believe that we are anywhere near the end of the bull phase.

I believe that one of the biggest concerns for India i.e. the current account deficit could be getting addressed due to the improving competitiveness of Indian exports. The trade figures for the last few months are indicating a strong export demand for Indian products. The rising cost of manufacturing in China and the rising wage costs in that country will continue to improve terms of trade for India in the export markets. The trade deficit projection for a 12 month period for India was around USD 120-130 billion. However the trade deficit for December 2010 was just USD 2.6 billion. These figures if sustained can reduce the Current Account Deficit risk premium for India. Indian exports grew at 33% in December and Chinese grew at 17%. There are obviously a large number of industries where India is not present as of today and where the Chinese are very strong and established. However India’s demographics and relative currency movements will make Indian exports continually more competitive over the next few years. A reducing trade deficit not only makes the economy less susceptible to sudden capital flow reversals it also adds to GDP growth. Given the interest rate differentials the forward premium that exporters realize on their bookings is also very attractive and adds to the profitability of exports. Rising crude prices can obviously impact the deficit however not substantially.

On top of that services exports are also doing very well today and this will further have an impact on reducing the current account deficit.

The other big concern tha
t investors domestically tend to have is that of foreign investors suddenly deciding to abandon India and pull out money big time. I believe that this will only happen during a kind of crisis that we had in 2008. Given the fact that India today has the 8^th largest market capitalization in the world there is no way that there will not be money inflows into India give the long term growth prospects. As such improving growth prospects in the US or a stronger dollar can impact flows in the short run but not their long term direction.

The growth outlook for the Indian economy continues to be strong led by strong consumer demand which is driven by high rural incomes, strong hiring and good wage increments. One just needs to go to the malls over the weekends to see the start of the consumption boom in India. With the percapita GDP crossing USD 1300 and likely to reach USD 2000 over the next four years consumption will continue to be a big driver of the economy. Services continue to grow well and the only concern could be on the investment cycle given the kind of procedural delays, environmental issues, policy delays etc that we are facing. Rising interest rates could also impact investment demand in the short run.

Then there are novice technical chartists who are predicting that because some trend line which has held since the start of the bull market has got breached the bull market is over. I will request these people to look at the corrections of May 2004, May 2006, and February 2007 and then make such predictions. Trend line breaches commonly happen and are essential for the survival of the bull markets as it is necessary for the bears to become confident to short the market which makes the base for the next up move. These chartists should infact look into the fact that 7 major markets are at new highs and such a phenomenon usually would imply that other markets will eventually follow.

The concerns for the markets continue to be the same i.e. the stubbornly high inflation which has been largely driven by primary articles and the Euro zone debt concerns. These will continue to have a cyclical impact on the markets on an ongoing basis. The overheating of the Chinese economy and its tightening cycle will also impact the markets on and off.

Thus on an overall basis I believe that although I might have turned bullish prematurely after actually targeting a level of 5450-5550 for the Nifty throughout the last quarter of 2010 the overall outlook still seems to be for a 5% downside risk and a 30% upside by the end of the year 2011.

To repeat a saying from one of my earlier articles – “More wealth has been destroyed in waiting for corrections than in corrections itself”- Peter Lynch