Two months of drift – Could June be better

The month of May again turned out to be a boring one for the stock markets. The markets drifted down right from the beginning of the month and we saw a slow and steady decline in both the front line and broader indices in the first three weeks of the month. The drift in the markets started with the RBI’s monetary policy at the beginning of the month where the hike in policy rates as well as the undertone of the policy was extremely hawkish. This has now created growth concerns for the economy in the near term without changing the long term outlook for the markets. The Nifty & the Sensex ended with losses of 3.3% for the month.

The other key developments during the month were the much anticipated election results, which were on an overall basis pretty good for the Government and as a follow through for the markets. The Industrial Production numbers as well as inflation surprised on the upside and the GDP growth figures released at the end of the month were slightly below expectations.

One positive figure that came out at the end of the month was the actual Fiscal Deficit figure for the last year which came at 4.7% as against 5.1% projected at the time of the presentation of the Union Budget. In one of my articles at the beginning of February I had pointed out that Fiscal deficit should not be more that 4.1%. However despite accounting for huge amounts of additional fuel and fertilizer subsidies in the month of March 2011 the Fiscal Deficit still remained well below the governments projected figures.

We believe that the markets are now bracing up for a strong up move in the second half of the year. As we had anticipated there was a severe sell off in commodity prices in the first half of the month. The key to observe now is whether we have seen the worst of the commodity correction or there is one more leg to go. I would think that we could see one more round of commodity price sell off before things stabilize for the commodity universe. Although a correction in commodity prices is extremely positive as far as India is concerned the only issue for the near term is that typically when commodities see a severe sell off markets do not rally at the same time and typically do that with a lag.

Typically strong markets up moves are followed by a correction and a phase of consolidation. However the market sell off in the year 2008 saw a rapid bounce back without a multimonth consolidation phase that followed the rallies in the early 1990s as well as in 1999-2000. As such it is our view that the consolidation of the markets in the range of 5000-5500 Nifty for a greater part of the last two years has actually a sideways correction which will give way to a strong up move, starting the second half of this year. A lot of trading interest in the markets has shifted to commodities; especially over the last 9-12 months as typically trading interest is more in asset classes that have done well in the immediate preceding period. This has created a scenario where the broader markets in terms of small and mid cap companies in India have become extremely cheap relative to the growth prospects. We expect this undervaluation to get corrected over the next 2 years where this segment of the market should provide very strong returns to investors.

The markets in India are now trading at a value of around 80% of current years projected GDP. At the peak of the last bull market in January 2008 this value had gone upto as high at 160%. Over longer periods of time the market capitalization in a country will be a proportion of the value of the Gross Domestic Product. In phases of high earning growth and margin expansion this ratio will also expand and in phases of margin squeeze and lower earnings growth this ratio will move down. We expect that as the bull market moves to its next phase and reaches a peak 3-4 years from now the Market Capitalization/GDP ratio will again go back to its euphoric levels of 150% plus. This would mean a tripling of India’s market capitalization over the next 4-5 years. As such the current phase of apathy towards equity investing could be one of the best times to actually invest into the markets.

Most of the concerns as far as domestic factors are concerned i.e. those related to inflation, lack of policy making, tight liquidity, lower earning growth etc. seem to have been factored into the markets at this stage. However an unprecedented global event like that of a default by one of the troubled Euro zone countries can lead to a short term sell off in the markets. However given the fact that it is an event that is not unanticipated, its impact should be short-lived.

Overall we are quite constructive and bullish on the markets at this stage and we believe that the markets are looking good for investors with a 1 to 3 year perspective. Whereas large cap stocks could return 20% in this time frame the returns form mid caps could be double of this. A recent phenomenon over the last few days has been a pick up in Merger and Acquisitions activity, specially related to small & mid cap companies where these are typically happening at valuation that are at a premium of 50-100% over the current market value of these stocks. The M&A in privately held companies is also at a significant premium to the valuation for similar companies that are listed in the markets. This clearly shows that the SME segment is trading at a very high undervaluation at this stage.

Directionally we believe that the markets should move to a level of 22-24000 for the Sensex and 6800-7000 for the Nifty before any major correction happens now.

“In the short run the market is a popularity contest, but in the long run it is the strength of your convictions that matters”