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Over several quarters, the equity market has witnessed great volatility. The market has continued to sway between over-optimism and over-pessimism every now and then, caused by patchy economic fundamentals, sharp change of events/newsflow and lack of counter-balancing fund flows. It is imperative, in this scenario, to remain focused on fundamentals and make gradual changes in one’s portfolio as the future unfolds.
The macroeconomic challenges faced earlier during the year seem to be on the wane. Revival in foreign equity flows, subsequent to postponement of QE taper by the US Federal Reserve and the Reserve Bank of India (RBI) actions to bring in dollars through the foreign currency non-resident route, have resulted in a pullback and stability in the rupee against the dollar. The current account deficit (CAD) seems to be a problem of the past. Trade deficit numbers for September came in at $6.7 billion, the lowest level in 30 months. Not just oil and gold, even non-oil, non-gold imports have contracted considerably, a good sign. We expect FY14 CAD to be $50-55 billion compared to $88 billion in FY13. The markets have definitely got more time to adjust and prepare for the eventual tapering.
Clearly, until now RBI focused on issues related to external front and currency volatility. Going ahead, the focus will be towards taming inflation, sticky for long.
On gross domestic product (GDP), we are expecting about 4.5 per cent growth in FY14. This is based on assumptions of better agricultural GDP in the second half (Q2) due to good monsoons. While the macroeconomic challenges are on the mend, we believe the markets will move in line with corporate earnings and re-rating is dependent on signs of economic recovery or expectations of a stable coalition after elections.
After the recent sharp-up move, the market is now trading close to long-term average valuation levels (currently 14.5 times one-year forwards compared to the long-term average of 15.2 times). We believe we are close to the bottom of the earnings downgrade cycle. Although the earnings growth expectations for FY14 are modest at about six per cent year-on-year, we expect this to improve moderately to double digits in FY15. The market is likely to track expected earnings growth over FY14 and FY15, around double digits in compound annual growth rate terms.
Overall market valuations, which are in a fair zone, do not reveal much. The defensive basket of information technology (IT), pharmaceuticals and fast moving consumer goods sectors are quoting at valuations of 25 times on an average in price to earnings terms, while the rest of the market is at around 10 times. The market is valuing growth, balance sheet strength and security of earnings growth at a premium. The beaten down stocks/sectors seem very attractive on valuations, the risks are also quite high in that basket. Therefore, it is wise to have a portfolio balance in terms of both these segments. As the clarity on economic recovery becomes stronger and risks wane, cyclical sectors can occupy a larger proportion in the portfolio.
We are currently overweight on sectors such as IT, telecom and automobiles. The IT industry is witnessing renewed business momentum, along with added boost in terms of year-on-year currency depreciation. After years of consolidation, telecom sector seems to be on a better profitability and growth path. The automobiles sector is well placed to cash in impending improvement in economy in our opinion. The least favoured sectors are capital goods, power and engineering. As we believe that revival in the domestic capex/investment cycle is still some time away, we are maintaining an underweight stance on all related sectors.
Investors need to control not only greed and fear, but also euphoria and despair. The current range-bound market actually provides a great platform to make staggered and disciplined equity investments to cash in on economic recovery, as and when it occurs.
The author is head , equity, Kotak Mutual Fund
