To make the portfolio defensive, add stocks with dividend yields above three per cent.
Last week saw the sharpest single-session downmove in two years. It stress tested the accepted wisdom about buying for the long term and ignoring short-term considerations. It also established with brutal clarity that the bear market is very much alive and kicking.
Let's try and list the factors that led to such a toxic session. The immediate trigger was a downbeat advisory from the US Federal Reserve, coupled to sad noises from the IMF. Apart from US recession and monster deficits, the Eurozone remains on tenterhooks and Japan is nowhere near recovery from the Fukushima catastrophe.
None of this is news. One would expect much of it to have been already discounted. So we must assume that collapse came because the Fed's remarks sparked panic. This kind of panic occurs when there is massive, widespread uncertainty about the future and an expectation of further bad news.
What further bad news could affect sentiment even more adversely? After all, over half the global GDP (EU, US, Japan) is already accepted to be “missing in action” and nobody will be particularly surprised if things get worse in those parts.
There is also some significant signs of slowdown in China and other parts of East Asia. This too is not surprising, given the Asian Tigers' collective dependence on exports. The domestic Chinese economy is in reasonable shape. But by definition, an export-orientation means capacity surplus to domestic needs. That capacity is likely to be under-utilised until there's recovery in US, EU and Japan.
The Chinese have started trying to encourage local demand to absorb some surplus capacity. But it will take time. Slowing exports results in large chunks of the Chinese labour-force feeling unhappy and under-employed and consumers tend to defer discretionary spending in such circumstances.
India too will definitely suffer a slowdown. Interest hikes, persistent inflation, stalled infrastructure, falling corporate margins, and a political establishment crippled by scams is not a great recipe for GDP growth. The generic recipe for this sort of situation of low demand is pump-priming. If you throw money into building new infrastructure for instance, the investments help revive demand. This is not really an option anywhere in the world at the moment. Government finances are shaky and no government would like to gamble on increasing deficits.
However, from a contrarian angle, the panic indicates that the bear market may be heading towards its last and most destructive phases. Contrarians believe that when everybody is bearish, the selling pressure tends to ease off as everyone who intends to sell has already sold. We haven't reached that point of bearish consensus yet. But the majority of institutions are certainly bearish. Either this downtrend, or the next will flush out the last of the bulls. If this reading is correct, it means that, in terms of time, we are not far from a bottom.
In terms of valuations, there could be a lot of downside left. The average PE for the Nifty is at 17.6 and the last two bear markets have seen the index bottoming in the range of PE 10-12. If that history holds, there is the chance of a further 25-40 per cent correction in prices. It is entirely possible that we'll see a slide into the 3900-4300 zone if there is are further negative triggers.
The technical trend suggests that a bearish view will be worth trading with successive levels of 4700 and 4300 to watch for. Net-net, the short-term outlook is bearish and there could be a big downside. But the trend is likely to bottom and reverse in another 6-9 months and it may be possible to exploit this. There are several ways. Like seeking short positions until the market bottoms. Another method is to pick stocks with high dividend yields and average down. For instance, if you find large liquid stocks with dividend yields above three per cent, the portfolio will have good defensive value.
A more aggressive strategy is to find heavweight and midcap stocks that have suffered higher capital erosion than average. The Nifty has fallen 23 per cent. Many stocks have dropped over 50 per cent. Such losers can show spectacular capital gains, as and when prices rally. However, quite a few of the underperformers may never bounce back.
A third strategy is to stick to systematic passive index investing. But be prepared to increase the size of each commitment if the index falls below 4,700-4,800. This method would lower the average cost of acquisition more than an equally-weighted systematic investment plan.
