WHAT NOW

The stock markets have bounced back quite smartly from the depths that they saw in the months of January and February. At the end of February when all hell had broken loose with most people expecting the markets to correct further and the Nifty and Sensex to reach 4800 and 16000 respectively, my view was that we are likely to see a rally of at least 10% over the months of March and April. Although I have taken a somewhat conscious decision not to predict very short term market movements as they are like “Crystal Ball Grazing” the psychology of the markets combined with the fundamental factors made me confident that the markets seemed to be undervalued at that stage. I had also anticipated that mid caps should start doing well from April onwards and we have seen some buoyancy come back to this part of the market with most of the small and mid cap stocks rallying 20-40% from their bottoms over the last couple of weeks. However most mid caps are trading well below the levels seen in November 2010. This is at a time where the Russel Small Cap Index for global small caps is trading at all time highs. Small and mid caps in India are still trading way below not only their all time highs seen in Early 2008 but also well below the levels seen in October/November 2009 after the first burst subsequent to the market bottom led to a large number of these stocks shooting up by 4-5 times in just around 6 months. I still continue to believe that the valuations on a large number of small and mid cap stocks that we see today are similar to those seen after the Emerging Markets crash in May 2006. A large number of these companies have grown multifold in this period and still trade at market valuations that are 20-30% of those seen in 2008. Even if we were to argue that the January 2008 levels were those of gross overvaluation, still the values seen today seem to be of significant undervaluation.

As we enter the results season what we need to see is the factors that are likely to impact the markets and individual stocks in this period. On top of this we have the macro environment and the need to evaluate the impact of various events that are happening globally on the markets.

The key factors domestically seem to be

Inflation – Food inflation seems to be cooling off sharply and this was one of the major factors that influenced markets in the month of January. Food inflation that had shot up to as high as 20% in early January is likely to fall to levels of 5-6% over the next 2-3 weeks. This will be due to a combination of high base effect and also falling prices. The good thing for India is that the current crop season has been extremely good with record production of wheat, sugar, pulses and other food grains. A large number of other global commodities also seem to have stabilized with the exception of crude, gold, silver and other precious metals. However we seem to have seen the peak of inflation in India and although the pace of decline will be slower than earlier expected (mainly due to high crude prices) the overall trend seems to be for it to go lower. In terms of tightening RBI has been one of the most aggressive central bankers and as the Chinese and Europeans drop in we should see some softening of commodity prices going forward.

The counter impact is due to the continued money printing by the US Fed and the recent liquidity pumping by the Japanese. However inflation in is likely to hit the shores of the US earlier than later and will force the US Fed to act. The continued looseness of the US policy has led to a sharp drop in the US Dollar and further boosted the USD carry trade. However I believe that the bigger carry trade over the next couple of years will be the Yen carry trade with the Yen expected to depreciate due to poor economic fundamentals. However on an overall basis the entire trade of selling inflation facing emerging markets like India, China and Brazil in favor of Western markets seems to have to come to an end and we should see an unwinding of this trade going forward. Given higher growth prospects EM’s should come back into fancy now.

Liquidity – The liquidity tightness kept by the RBI took borrowing costs up sharply in India over the last 3-4 months with rates for some deposits and loans shooting by nearly 200 basis points or more. However liquidity seems to be easing now and this should be positive for economic growth. Global liquidity is extremely strong and this has also led to a sharp increase in oversees borrowings by Indian corporates as the all inclusive cost of USD borrowings gives a benefit of at least 2 percent over domestic rates at this stage.

Policy Making and order flow improvements – After the series of scams and slowdown in government policy making things seem to be coming back on track now and this year should see record orders being places in the Roads & highways segment. Corporate Capex also seems to be chugging along at a good pace. With the softening of the Environment Ministry’s position on awarding projects we should see higher activity in the mining segment and also in large Greenfield projects in the metals and infrastructure segments. Order flows from large Public Sector Enterprises had also come to a standstill due to the various corruption scams that came out. This should also improve going forward. Also with the government looking at higher FDI flows some relaxations for such flows and opening up of some industry segments should be seen this year.

Other factors –

PIGS – PIG gone S left – Its amazing that the bankruptcy of Ireland, Portugal and Greece has hardly impacted global markets and has infact been accompanied by a sharp rally in the value of the Euro. The Euro which was believed to be a currency in peril has come through the crisis very well. With the USD and JPY in doldrums, the Euro has seen a sharp revival. Spain as per what the bond spreads indicate seems to be in a much better position than it was at the beginning of the year with credit spreads for Spain contracting by 150 basis points over this period. This removes one big overhang on the global markets given the size of that country and its economy. However it might be too premature to give it an all clear.

MENA – The crisis in the Middle East and North African countries has an impact on the global economy not due to the size of those economies but obviously their oil supply disruption potential. The key for us to evaluate today is that whether a USD 125 price for Brent and USD 112 for US Crude (when inventories are at all time highs) has built in most of these concerns. In my view the worst except for a big revolution in Saudi Arabia seems to be in the price of crude today. The probability is very high that we will see a significant sell off in crude and precious metals if the situation in this region stabilizes over the next couple of months. However on an overall basis this is something that seems to be unpredictable at this stage. US crude that was trading in the mid 80s at the beginning of the Libyan crisis is now at 112 levels per barrel thus reflecting a political risk premium of over 30% and this seems to have factored in the worst o
f oil supply disruptions at this stage. Speculative flows can sustain the prices for some time but not for a prolonged period of time.

Flows – The continued outflow from Emerging Market equity funds in favor of developed market equities was one of the prime reasons for EM underperformance from November 2010 to February 2011. However the last two weeks have seen a sharp reversal in flows to EM funds with flows of USD 2.3 billion followed by USD 5.6 billion in the last week. This has happened at a time when short positions in the markets seem to be quite high and most investors are still very skeptical about the rally. If one watches the electronic media business channels (which I avoid) most investors still are of the view that the current rally is a pull back rally. This infact makes me more confident that this is a more sustainable rally. The good part for the Indian markets specifically is also that domestic mutual funds have started to see strong net inflows. The net market flow position from domestic insurance companies also seems to have bottomed out. Domestic insurers pumped in just around Rs 4000 Cr in to the markets in the 12 month ended March 2011 which is nearly an 80% plus fall from Rs 30000 Cr plus last year. I guess the next year should be better for insurers also. Domestic MF’s that pulled out Rs 20,000 Cr plus should be pumping in at least this number over the next one year. In conclusion the overall flow picture seems to have improved sharply for the remainder of the year.

Rupee – The fact that the INR did not depreciate despite the sharp sell off that we saw in the equity markets and rising fears of increasing current account deficit due to higher crude prices was a clear indicator that the correction in the stock markets was likely to be a short one. Technically the rupee seems to be well positioned for a sharp up move over the next few months. The continued improvement in the growth of Indian exports over the last six months has surprised lot of people. This has kept the Current Account deficit at levels of 2-2.5% for the current year and it should be lower than 2% next year as the position of invisibles flow also has improved, especially that of IT exports and remittances from the Gulf countries given the high prices of crude oil. Typically INR movements and the markets have been highly correlated.

OVERALL OUTLOOK

My overall outlook is constructive on the markets at this stage. We could see some consolidation of the markets after the sharp up move; however the trend seems to be for the markets to see much higher levels this year. The results season is unlikely to impact the markets significantly and the impact will be positive for mid cap stocks that surprise positively given the extremely depressed levels at which they trade. Bull moves are build on skepticism and fear and there are indications of both at this point of time. Oil prices are a headwind but not an insurmountable one. It is clearly a buy on dips market at this stage. My base case view at this point of time is for the markets to rally 10% above their highs seen in January 2008 at some point during this year. That would imply a 20% rally over the current levels. Mid cap outlook seems to be much better.

“ We have two classes of forecasters: Those who don’t know and those who don’t know they don’t know.”-Jhon Kenneth Galbraith.