The extent of the rally is a surprise, but we need to tread water for some more time.
I will be the first to admit that this rally has caught most people, including myself, by surprise. Sure we were expecting some type of bear market pullback, given how oversold the markets had become, but nobody expected a rally like the one we have seen. The move over the last six weeks has been in excess of 35 per cent, and even the most die-hard bear has been forced to reduce risk and take notice. Besides, as far as bear market rallies go, the move in terms of percentage has been greater than most, and thus is a cause to ponder on what is really going on. The rally has caused tremendous pain, as most have been unable to participate fully, being under-invested or invested in very defensive sectors and stocks.
There is a tremendous feeling of being left out, and some observers are even calling for a new bull market.
The question is what does one do now? If you are under-invested should you chase the market? Or should one use this rally to lighten up on stocks that one wished one hadn’t bought in the bull phase? The markets both in India and globally now seem to be going through a churning phase, where they will pause for a bit, catch their breath and we will see a battle between the bulls and bears.
I still feel that one should focus more on capital preservation, rather than trying to take on additional risk by chasing the markets here. If you already have significant investments in India like we do, then there is no need in my mind to try and double up and increase risk at this point. Given how much money is still on the sidelines, the markets may not retrace all the way back to 2,500 levels (Nifty), but I can’t see the case for a significant upside from here either, in the short term.
Firstly we have the elections staring us in the face. By all accounts this is the most open election ever, with at least six leaders in the running to become PM. Nobody is quite sure how it will turn out, and as of today any of the three formations could come to power. I am not in the camp that politics do not matter. They may not have mattered when the world was growing at 4-5 per cent, and India had enough of a tailwind through heightened risk appetite and the benefits of past reforms to grow at 8 per cent-plus. However, they matter today, when the world is in the midst of a recession, we have structural fiscal issues and strong economic decision-making is the need of the hour. India has enough policy-based low-hanging fruit, that its growth can be protected at a relatively high level. But will we get the policy reform? The only way that India can be re-rated upwards in terms of valuation multiples is if we get strong policy action. Depending on which formation comes to power, and who is the PM, there is no guarantee that we will get the dose of policy action that we need. There is not an insignificant probability that we get stuck with a very weak and ineffectual government that may not even last a full term. Such an outcome is a recipe for inaction and policy drift.
Secondly at current levels, the markets are now trading at 13-14 times March 2010 earnings, not really that cheap. We can find many companies in the midcap space which are very reasonably priced, but frankly I still struggle to find real value in the large-cap universe. Things don’t seem cheap enough for a real bull market to begin here. We may of course be wrong on earnings, which could surprise on the upside, and markets may be cheaper than they currently look. One can calibrate this view as we get more evidence of the real earnings power of corporate India. One of the mistakes a lot of us have made in this cycle is to give multiples to one-off earnings and not test the earnings for sustainability. In hindsight investors paid peak multiples on peak earnings. Having over-paid in the last cycle, investors will naturally want to be more cautious on assessing real sustainable annuity-based earnings today.
Thirdly, if markets even hold here, I think there will be a deluge of equity issuance. The paper will flood the markets and eventually cap the upside, at least in the short term. Corporate India having been denied equity capital for 15 months, is just waiting to correct its capital structure in certain sectors. The quantum of possible issuance will be more than enough to soak up most of the capital sitting on the sidelines.
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Another feature of the rally has been that it has been led by the stocks and sectors which have been beaten down the most. Bear markets such as the one we are going through, serve the purpose of purging excesses and changing leadership. It is highly unlikely that the sectors/stocks which drove the rally in 2007 on the way up, will once again lead the market when we enter a new sustained upmove. Given the type of stocks leading this most recent rally, it still smacks of short-term momentum players and short covering, the stock/sectoral moves do not seem to indicate this is the beginning of a new sustained bull phase.
Having said all of the above, the reality is that there is a lot of money sitting on the sidelines, and a strong left-out feeling. It is unlikely that markets get back to the levels we saw in early March, which has a reasonable chance of being a bottom. In the next downward move, a lot of this money sitting on the sidelines will get sucked in and prevent a retracement all the way back to 2,500. My own sense is that markets will drift and we will get more of a time-based correction. The majority of the price destruction is over, but we need to tread water for some more time. The markets will trade in a narrow band, volatility will reduce and the remaining excesses will be wrung out over time.
Ultimately in the short term, liquidity drives markets, and we do run the risk that equity flows into the emerging market universe will continue to accelerate. In search of beta and momentum, asset allocators could pile in. In such a case investors will be forced to buy, irrespective of their conviction.
If markets globally continue moving up, we could see capitulation among many large long-term investors who, sitting on the sidelines till date, will now be forced to participate. We are very near the pain point for many of these institutions. The next few weeks and a level of 850-860 on the S&P 500 is critical.
In India I still feel one can afford to wait till the elections, and then decide the course of action. I would not chase here. I still feel a focus on preserving capital is more important than maximising upside at this point.