How does one form a short term view on markets influenced by events?

The last three months have been strange or for the want of a better word “Frustrating” given the fact that the assumptions under which one forms a view have kept on changing so fast that forming a view by itself has become a challenge. This is not only true for ordinary mortals like us but also for central banks and policymakers where as an example the RBI had expected inflation to moderate to 5-5.5% by March 2011 in its policy in October (I think) and in the latest policy they have upgraded the target to 8% (They have been underestimating inflation for so long that I think this time they have played it safe by conjuring a figure that is difficult to beat). Events related to the 2G scam, corruption issues & now the Wiki leak cables have been the domestic factors and the happenings in North Africa & the Japanese earth quake and the following nuclear crisis have been the international events that have dominated headlines and affected markets negatively. Under the circumstances it has become challenging to form any short term view on the markets and also futile to an extent. My observations at this stage would be –

Markets have factored in most negatives but are suffering from a lack of confidence – The markets now have been in a corrective phase for the last five months in which all the above mentioned events have affected the markets negatively. Most investors are frustrated with the markets and that is reflected in retail trading volumes as well as in the Futures and Options positions that stand at very low levels. Infact if one removes the F&O position of FII’s then the positions become even lower. Stock future positions are vey low and this reflects a very low speculative element in the markets. Emerging market funds have been losing money every week and have estimated to have lost USD 23 billion YTD and this has become the longest losing streak in the current bull market. Inflation seems to have peaked out in India (unless off course Crude shoots up another 10-15%) and the liquidity tightness seems to be at its peak. Governance issues seem to have peaked out on the negative side and things seem to be settling down on that front too. Corporate India amongst all of this has continued to perform well and the Advance Tax figures for March are reflecting a strong performance as far as March quarter results are concerned.

As one talks to a large number of corportes across industries the main point that comes out is that demand continues to be strong and corporates are positive on future outlook. However now they have started becoming a bit concerned on the pace and extent of rise in interest rates while being quite benign but concerned on global events.

Small and mid cap stocks are trading at valuations near to those were there during 2004 and largely do not take into account the growth prospects while factoring in most risks into the stock prices. The way mid & small caps have got battered over the last 4 months it reflects extreme fear in the minds of investors. The good part for investors willing to buy into the markets at this stage is that in the current fall the markets have not distinguished good & bad businesses, companies with strong cash flow and those that could have issues related to tight liquidity, companies with no execution risks & those with high risks etc etc. This provides an ideal opportunity for stock picking with a longer term view where the short term factors will stop having a disproportionate effect on stock prices.

The consensus estimates for earnings of next year have been scaled down substantially and most analysts have factored in the margin pressures due to higher input costs as well as higher interest costs. This has been done by extrapolating today into the future which might not hold true. For example as a result of Chinese tightening, end of QE 2 of the US Fed and the start of the tightening cycle by the ECB we should see commodity prices being under pressure in the second half of the current year. As inflation eases off and liquidity improves we could also see interest rates stabilize and maybe also have a downward bias later during the year. Valuations based on consensus are today 14X next year earnings which are attractive with a medium term perspective.

Most investors have been allocating a disproportionate share of their investments into fixed income products that are yielding near double digit returns and commodities, which frankly look extremely overbought to me and do not take into account global growth concerns and reflect an extreme degree of speculation. This could be a trade that will be hard hit sometime in the near future.

Under the circumstances it seems so me that we are more in a time correction phase as the event risks die out rather than there being likelihood of any significant sell off from where we are today.

My trade at this point of time would be to keep on nibbling into stocks that one would like to hold on for the long term without bothering about short term fluctuations.

Frankly, predicting the short term has become like Crystal Grazing – defined as “
staring into a crystal ball to arouse visions of future or distant events”.