After behaving in a decoupled manner from the beginning of March to the end of the first half of the current year where emerging markets outperformed and moved quite independently than that of western stock markets and outpeformed them significantly, all of a sudden a recoupling in the markets has taken place due to surprisingly a very strong set of results from a majority of companies in the United States.
Although results of companies in India have largely been a mixed bag with companies in the Technology, Automobiles and Cement outpeforming expectations and companies in the fancied sectors of Banking & Financials along with Engineering & Capital Goods largely underperforming expectations. However most companies reporting out of the United States have largely outperformed expectations and in a large number of cases by a wide margin. This has created a phenomenon where emerging markets are today being driven by results out of the US rather than results in their own countries and we have seen a huge positive steak in the markets where the Nasdaq has gone up continuously for 11 sessions and the Dow Jones as well as S&P indices have also seen a very strong run up. This has resulted in emerging market stock markets moving up further after a very strong run that was seen in the last four months.
Just when consensus had started building up on a correction in the markets the US markets started to move up and drove up the emerging markets.
As far as the Indian markets go they did correct by nearly 15-20% from the top as I had expected, however the rebound in the markets has taken me somewhat by surprise. I had expected the correction and the subsequent consolidation phase to last for a period of atleast a period of 4-6 weeks. However subsequent to the correction post the presentation of the Union Budget the markets have moved up by nearly 16-17%. The strong showing by the Chinese markets is also one reason for the global market upmove where that market continues to defy gravity and has been moving up continuously over the last several months. The economic growth numbers coming out of China have also been very strong and have been driven by the Chinese governments stimulus efforts.
Other factors contributing to the global markets rally has been a continuous weakening of the US dollar and falling volatility reflected by VIX which has fallen from nearly 90 after the crash in the markets in October 2008 to a level of 23 as of yesterday. Emerging markets as a group have got an inflow of nearly USD 32 billion from March of current year which is a record of sorts as in the last quarter of 2007 before the markets crashed in 2008 the inflows were in the region of USD 23-24 billion.
In the current context given the volatility in the markets and the pace of the upmove seen in the recent past it is becoming difficult to take a call on the immediate direction of the markets. I believe that there are two possibilities that exist as on today
Scenario I – The markets continue to rally in an euphoric manner over the next 2-3 weeks driven by strong capital flows and good results flow from the US markets. Key economic growth numbers, which are showing improvements at different levels in different countries also keep on feeding into the positive sentiment. The dollar carry trade continues to play out strongly as the dollar continues to fall in value and given the extremely short term rates money keeps on pouring into risky assets which includes both equities and commodities. Most commodity prices have also seen a strong rally with a big upmove in the prices of copper, aluminum etc..
This euphoric upmove will be followed by a strong selloff where the markets can fall very sharply and as much as 25% from the top.
Scenario II – The markets stop to keep stock of what has happened over the last few months and take into account the fact that although things have stopped declining and stability seems to be interesting in most Western economies a strong rebound is some time away. In the Indian context markets take into account the fact that
-markets are not very cheap after the strong rebound and are trading at around 17-18 X current year earnings. The Price Earning ratio is at a level which is almost a double of the trough valuations of March 2009 and also is higher than the historical averages.
-Markets also take into account the risks of the delayed and below average monsoon on agricultural and economic growth.
-The strong fund raising in the markets due to QIP’s and other instruments has taken away a large part of the floating liquidity. Although this is positive for economic growth prospects and gives equity capital for the companies to grow and deleverage their balance sheets. However the big cash levels that mutual fund companies, hedge funds etc. had has largely dried out.
– Results have been mixed with a combination of outperformance and underperformance
In the second scenario the markets would consolidate with the current levels of the markets being more near the upper end of the band and the lower band being around 10-15% lower.
Although I personally would like to give a greater probability to Scenario II, the market consensus seems to be veering down to Scenario I where most market participants are looking at a further market upmove of 10-15% over the next few weeks. Lets see how it plays out, however if Scenario I actually plays out in terms of a further momentum upmove it will be followed by a very sharp correction.
It will make sense to increase cash through this upmove to buy cheaper in the fall.