Investors will return to equities only when credit markets ease up and bond spreads decline.
This is truly an extraordinary period in financial markets, with investor fear all pervasive. We have yields on bonds at all time lows, the dividend yield on the S&P 500 higher than bond yields for the first time in decades, and a mass sell-off in all growth assets. In addition we have weakness in all emerging market currencies, and capitulation across commodities. Specific financials hit new lows on a daily basis, and despite the US treasury and Fed going to overdrive in spending money to unlock lending and liquidity, markets seem unwilling to respond.
Even in India, investors have been battered and bruised, with markets coming down relentlessly. There seems to be no respite, as the selling from FIIs continues unabated. Many of us have been doing this for a long time, but never have I seen markets fall by 70-80 per cent in a matter of 10 months (the decline for a dollar based investor). Having gone through this pain, investors are naturally wondering as to when it will end. India has not collapsed, and we should still have reasonable economic growth, so why are people still bailing out of our markets even at these levels? What will bring them back?
For investors to come back I think we need two or three things to fall in place:
First of all, the Indian economy clearly froze in end September-October. We know of numerous companies which report demand falling off a cliff. While conditions have improved in November, we are still limping along. While the problems were largely caused by global trade finance and local working capital issues which should normalise soon with the RBI becoming proactive, many investors believe this is only the beginning of a far more dramatic slowdown. Why can't we go back to 2003 or even 2001, when GDP growth was only 4.5 per cent, is a question many investors are asking. The first quarter of calendar 2009 will be critical to judge whether demand is stabilising or we are going into a free fall. The bears see huge earnings and GDP risk, with a reversal of the corporate capital spending cycle, collapse in exports and a severe slowdown in consumption. The bulls point to the strong income growth in rural India, the fiscal stimulus of the Pay Commission and the huge improvement in India's macro with falling commodity prices. No matter which side of the argument they are on, investors are going to wait to see how the economic numbers pan out in Q1 2009, as nobody has the risk appetite to take a bet. The unprecedented nature of this crisis has left investors with no ability to dimension the downside, and thus, till they see economic stability, it is unlikely that investors will re-enter the markets aggressively.
Secondly, the credit markets have to ease up and bond spreads come down. It is for example possible currently to buy convertible bonds of Tata Motors at a yield to maturity of over 30 per cent, or Reliance Communications CBs with a yield to maturity of 28 per cent, or Mahindra at 21 per cent. With these types of yields in dollars available, why will someone buy equity? Also, these bonds are available in reasonable size. It is unlikely that equity markets can move up sustainably without these yields normalising first. Till such time as we have yields of this magnitude, it also implies that the financing window for Indian companies remains closed. With no external financing, most investment plans will not go ahead.
The third issue deals with who will be the buyer of last resort. Bear markets exist to change sector leadership as well as move stock from weak to strong hands. In a normal bear phase, the weak hands, viz. leveraged investors, retail, speculators, etc., sell out and the real long-term investors like pension funds, insurance companies and endowments, etc., pile in, attracted by the cheap valuations. They know that if they have holding power, and can withstand volatility, the cheap entry price should ensure strong long-term returns. In India we have seen the selling out of weak hands, as more than $13 billion has exited the market from FII selling, but barring local insurance companies, very little strong hand buying. The reason for this is that most of the real long-term quality money globally seems to have short-term liquidity issues and is over-allocated to illiquid vehicles like venture capital or private equity. Having changed their model from a simple bond/equity asset allocation towards more alternatives, they do not in the short term have the ability to rebalance portfolios towards listed equities. This rebalancing used to act as a natural shock absorber to stabilise markets.
There is limited firepower available with this group to stand against the tide and be contrarian. For the limited capital that is available, there are many attractive investment opportunities globally across asset classes.
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Even locally, though we are yet to see major redemptions among the local mutual fund complex, there are very limited inflows. There also exists the risk that we will see a shift among existing investors in ULIPs away from equity, and even a mix shift away from ULIPs themselves among new life insurance policy holders. If either of this were to happen, the only strong hands buyer in India will also get constrained. The only sign of hope here is that many companies have announced buybacks and numerous promoters are also doing creeping acquisitions. In India, companies/promoters may be the strong hands that ultimately set a floor for our markets. One needs to track this (strong hands buying) closely, as without stock moving into long-term stable hands, we will not form a sustainable base.
Valuations have now come down to more reasonable levels, with the Indian markets no longer expensive at least on an absolute basis. India has always been a stock picker's market, and at some stage micro stock-specific analysis will come back in fashion. Over the last two years macro has clearly trumped micro, with broad market and sector calls being far more important than any stock-specific work. This is also a cycle and at some stage stock-specific work will become relevant to making money again. India should do well in such an environment, as the country's strength remains the quality of its entrepreneurs.
While all is not lost, the fact remains that there are many very attractive investment opportunities globally. India will come back, but we need to track the above sign posts closely.