WAVE 3

A number of people keep commenting on the direction of the markets in the long run as well as their views on whether the current move in the markets is the start of a new bull move or a bear market correction. As I have stressed in my earlier articles I clearly believe that it is the start of a new bull impulse.

My view is that WAVE 1 was the big bull market of 2003-2007 which lasted for a period of around 58 months and in this move the markets moved up from a level of 3000 to 21000 in terms of Sensex movement. This up move was part of a global up move backed by strong growth across the globe with both developed and developing countries growing strongly. The move was backed by strong liquidity flows and ended with the financial sector meltdown and high inflation. The good part of the up move for a country like India was that after having learnt from the example of the 1990’s there was no indiscriminate borrowing and capacity expansion by corporate India. The balance sheets of most large groups remained reasonably robust even after the strong excesses which marked this move. Some new groups that had emerged did see grandiose plans being made and there was a sort of asset bubble which was formed in the real estate sector. However this was reasonably muted in the overall context of the economy and the strong bout of monetary tightening by RBI combined with the control of overexposure into the sector from the banking sector prevented a large scale blow off and most banks and NBFC’s rode through the crisis reasonably well. The earnings of corporate India grew by over 200% in this period and as such the markets which had bottomed at a Sensex level of 3000 in the earlier bear market bottomed out at around 8000 levels this time around. In Wave 1 the growth was a bit haphazard with lots of sectors picking up in a big way along with the growth of the rest of the world. This was a phase of global expansion in which the world economy grew at a very healthy rate and this led to a huge pressure on resources which let to significant inflation and resultant monetary tightening which slowed down the economy.

As Commodity, real estate, stocks etc. all went into bubble territory we came to Wave 2 where one by one all the bubbles finally burst as the financial crisis came to light in the Western world. Commodities continued to defy gravity much after the stock markets had started falling driven by huge flow of money into commodity hedge funds and a weak dollar. By the middle of 2008 even the commodity bubble started to burst. Wave 2 was a most nerve shattering one for most investors in any kind of asset class globally where real estate, stocks, bonds, commodities etc. all crashed and there was a huge flight to safety which led to a big rally in the US dollar and a big rally in US government bonds where investors were willing to buy treasuries at a zero yield also. As risk aversion grew outflows from most equity funds as well as global hedge funds increased in intensity and this accelerated the fall in the markets. This phase which was also global in nature ended in March 2009.

WAVE 3 which will be the most dynamic and aggressive moves in the Indian stock markets have started from March 2009. I believe that given the state of the global economy, specifically the USA, Europe and Japan nearly 50% of the global economy is not likely to participate in the next big up move. USA and Europe have big structural issues with their economies and their financial institutions are totally in shatters. It will take years to repair these institutions and encourage them to take the risks required to provide capital to the economy. The saving rates in these countries are abysmally low and with increasing unemployment and pressure on wages this would not increase significantly. Also given the fact that a large part of these economies are driven by consumption, given a combination of the above factors consumption is likely to remain very muted for the foreseeable future. The governments of these countries will be able to pump prime these economies through fiscal measures in the short run, however over a period of 5-10 years these economies are unlikely to grow at an average rate of above 2%. Infact the averages will be between 0-2%. In order to pay back the huge borrowings due to fiscal spending these governments will have to reduce spending and increase taxes eventually, which will again become a drag for these economies.

However this will be a period in which India specifically should stand out and show very aggressive growth. Given a combination of political stability, high saving rate, high capital flows, a strong financial system and huge investments in infrastructure development the economy will go back to a growth of 8-10% very very fast.

–As the huge deluge of dollars searches for returns and as the dual carry trade plays out we will see most developing countries with a potential for generating reasonable returns getting huge inflows both as portfolio flows and FDI.

-This will also be a period in which growth will happen with muted inflation and low interest rates. The reason why inflation will not pick up is that more than 50% of the global economy will hardly see any growth over the next five years and as such demand pressures will be low. This will resulted in commodity prices remaining suppressed (not withstanding the current rally backed by dollar weakness and expectations of economic recovery). Moreover the investments that have happened in capacity expansion over the last few years have led to an overcapacity in lot of commodity industries which is unlikely to correct in the near term

-External borrowings will remain cheap with the dollar LIBOR rates at all time low levels. Eventually the spreads on borrowings will also compress.

-Fiscal deficit which is pointed out as a concern will not be a concern for fast growing economies like India as repayment of these borrowings will be easy due to high tax collections growth due to strong economic growth and increasing tax compliance. Over a period of the next 5-10 years the country ratings of India by global rating agencies will also move up as most Western countries get downgraded.

-Given the fact that most corporates have come out of the current crisis without too much damage to their balance sheets (despite the currency derivatives and FCCB issues)

–the financial system has not seen a huge up tick in NPAs the investment cycle should remain strong. As the economy starts to recover and confidence comes back consumption demand will also revive very strongly.

Having learnt from the mistakes of the past corporates, individuals and the government will drive towards productivity and better delivery. Over the next two years India will see a huge increase in domestic oil and gas production which will reduce import dependence and provide a fillip to lot of consumption industries.

-A large number of private and public sector driven power plants will get commissioned over the next three years which will lead to a strong growth in electricity production and red
uce power deficits drastically. This will also lead to a fall in the abnormally high merchant power rates that we see today.

-An increased emphasis on the roads sector will see the highway projects again falling back in place after virtually no development on this front over the last five years. There will be large investments going into various kinds of low cost and mass housing projects which will have a huge multiplier effect on employment as well as the consumption of key inputs like cement, steel etc. Lower consumer credit rates will lead to a strong revival in demand for consumer durables.

-Unlike in Western economies where companies are being nationalized the Indian government is in an envious position where it can raise Rs 50000 crores every year with just small disinvestments of a few PSU’s. These resources can again be used for spending by the government in all its key projects.

Things to be watched out for will be the pace of economic reforms, deregulation in various sectors (particularly petroleum product pricing), tax reforms like the phasing out of CST, the improvement in the delivery efficiency of government projects like the Rural employment scheme, Urban Renewal scheme etc. Railways is one area which has been neglected a lot and investments in improving services and railway stations can also have a huge multiplier effect on the economy.

I believe that the pace of up move in the markets in WAVE 3 will be very strong and fast and this wave will be smaller in duration to WAVE 1 but much bigger in size. This wave will take the markets to a Sensex level of 35000 over the next 42-48 months. During the course of this up move there will be continuous upgrades to the expectations of India’s GDP growth and corporate sector profit growth. The current year should be a 15% earning growth year and the subsequent two years should see a 25-30% earning growth. WAVE 3 will ultimately end like WAVE 1 did in huge overvaluation (and will obviously be followed by a correction). The Sensex EPS should conservatively reach a value of 2000+ by the end of financial year 2013 and at a Sensex level of 35000 it will be a valuation of 17.5 x earnings which is fair in bull markets and is not exactly a very high valuation given the historic context.

I believe that this is just the start of the new bull impulse and investors should not be too much concerned about missing the first three months of the rally as there is a lot more to go.