Lifecycle of an Emerging Market:Different Phases to Identify

The Boom and the error of optimism give way to a crisis of confidence and fear, the error of pessimism...

The most pertinent question which is asked recently is the fact that whether we are in the preliminary stage of a bull market and whether the economic cycle is turning around for good in India? There are no easy answers as far as the timing of the bull market is concerned. From a generalized standpoint, we know for sure that there are four stages as far as sentiment goes i.e., optimism, euphoria, pessimism and depression and from economic cycle perspective it’s innovation, growth boom, shakeout and maturity boom and for stock market cycles there are six phases which we have discussed in details.

For business cycles and stock markets the most alluring part is that there is always life after death. A new cycle always emerges as if a reincarnation, with newer set of stocks and principles and it always tends to be different from the earlier ones. The only constant in the nature is “Change” and the constant changes which we see or observe over electronic media and travelling in different cities and states and countries gives an impression of the state of economic prosperity we are in, and its culmination into stock markets.

Likewise we have tried to put emphasis on events and symptoms of varying degrees in order to identify the lifecycle and stages of emerging markets. The more extreme the market peculiarities, the more easier it becomes to identify the phase of cycle the stock market is moving into. We have tried to put things in context and have also taken extracts from Marc Faber’s book, where the phases have been well articulated.

Phase Zero- After Crash

• Long-lasting economic stagnation or slow contraction in real terms
• Real per-capita incomes go flat or have been falling for some years
• High unemployement
• Little capital spending and international  competitive position deteriorates
• Political and social conditions become unstable(strikes, high inflation, continuous devaluations, terrorism, border conflicts, etc)
• Capital flight

Phase One- The Spark

• Social, political and economic conditions begin to improve(new government, peace treaties, adoption of market economies and capitalistic systems, introduction of property rights, etc)
• New economic policies(tax cuts and preferential treatment of foreign direct investments, removal of capital gain taxes, currency reforms, lifting of foreign exchange controls, permission for foreigners to acquire 100% of assets including real estate, removal of trade barriers, etc)
• External factors, discoveries of resource deposits, the rise in price of an important commodity, applications of new inventions and innovations
• Improvement in liquidity because of an increase in exports, the repatriation of capital and increasing foreign portfolio flows and direct investments
• The outlook of future profit opportunities improves significantly, as a result of one or several above mentioned factors
• The undertaking of large scale infrastructure projects that improve power supplies, road transportation and port facilities
• The privatization of entire industries

Phase Two- The Recovery Cycle

• Unemployement falls and wages rise
• Capital spending to expand capacity soars, as the improvement in economic condition is expected to last forever(error of optimism)
• Large inflows of foreign funds propel stocks to overvaluation
• Credit expands rapidly, leading to a sharp rise in real and financial assets
• Real estate prices increase several fold
• New issues of stocks and bonds reach peak levels
• Foreign brokers and other foreign financial institutions open offices
• Merger and acquisition activity picks up
• Inflation accelerates and interest rates begin to rise
• There are exceptions, however: When countries suffer from hyper inflation and depression at the same time, the recovery, which is usually brought about by a financial reform, will lead to declining inflation and interest rates.

Phase Three: The Boom

• Overinvestment leads to excess capacity in several sectors of the economy
• Infrastructural problems, bottlenecks and an excessive credit expansion lead at times, via rising wages and real estate prices, to strong inflationary pressures
• The inflationary pressures, however, may not take place for consumer prices
• The rate of corporate profit growth slows, and in some industries it begins to fall
• Usually, but not always, a shock such as sharp rise in interest rates, massive fraud, a business failure, margin call that cannot be met by a large speculator or some external unfavorable event  leads to sudden and totally unexpected decline in stock prices
• At times stock prices decline for no other reason than that they have run far ahead of themselves, and some speculators or insiders – in the know that the boom cannot go on forever and seeing that the profit picture is deteriorating – decide to take profit
• In such cases, it is simply a matter that at some point the supply of equities from the corporate sector and insiders exceeds the demand from the stupid and credulous public who, brainwashed by the bullish statements from the corporate executives and the press, continue to buy at any price

Phase Four – Downcycle Doubts

• Credit growth slows – unless monetary authorities act irresponsibly and attempt to prolong the mania and keep the economy in a state of permanent boom
• Corporate profits deteriorate
• Excess capacity becomes a problem in a few industries, but overall the economy continues to do well and the slowdown is perceived to be only temporary
• After a initial sharp fall, stocks recover as foreign investors who missed stock markets rise in phases on and two pour money into the market and as interest rates begin to fall
• It is not uncommon that foreigners increase their buying of stocks in phase four, since they tend to be latecomers to the investment party
• Some sort of major hook keeps investor interest in the market alive. They hook may be an economy that continues to grow, sharply declining interest rates, corporate profit that are still rising, or simply optimistic statements by business leaders and government officials
• The majority of stocks usually fail to reach a new high because a large number of new issue meet demand( the sellers who are mostly locals who either know better or are strapped for cash)
• However, it is possible that a stock market index driven by just few stocks makes a new high. The advance/decline line and the number of stocks hitting new all time highs will, in such case, not confirm the new high

Phase Five – Realization

• Credit becomes tight, bond spreads widen considerably and bankruptcies soar
• Economic, but even more so social and political, conditions now deteriorate badly. Consumption     slows noticeably or falls (car, housing and appliance sales are down)
• Corporate profits collapse
• Stocks enter a prolonged and severe downtrend and foreigners begin to exit
• Real estate prices fall sharply
• One or several big players go bankrupt (usually the ones who made the headline in phase three)
• Companies are strapped for cash and are often forced to issue shares at distressed prices. This increase the supply of shares and depresses prices even further

Phase Six – Capitulation and the Bottom

• Investors give up on stocks. Volume is down significantly from the peak levels reached in phase three – usually by 90%
• Capital spending falls sharply (error of pessimism)
• Interest rates decline further and reach their lows for the cycle
• Foreign investors lose appetite for new investment and continue to sell
• Rating agencies threaten to downgrade the country
• The currency is weakening or is devalued

It is not necessary that all the events matches in a picture perfect style in all the stages and  we shouldn't become too dogmatic about it. Generally Phase-Three is the most noticeable one and can be easily identified. It’s in phase three that we see once in a decade kind of mania and market completely losing its actual fundamental touch. Money making becomes extremely easy and quick bucks are made with huge volumes and intense momentum. Symptoms generally remains abound with

• Business capital and metro cities resembles a boom town- nightclubs packed with speculators and brokers who made handsome money in the stock market
• Volume of credit expansion explodes in the system and leverages play a greater role
• Corporate tend to make fairly large acquisition with leverages both overseas and domestic at exorbitant valuations
• Buzzwords such as LBO’s, M&A, PE fund, Venture Capital, Rising India, Superpower are used frequently. Speculator tends to remember only the script code rather than the company name
• FII flows hits a crescendo with buzzword like the ETF money, Hedge Funds etc., etc., becomes rampant
• People generally argues for a structural bull market with lofty index and stock targets and gives arguments why the stock market or the property market cannot go down
• New airports are planned for and SEZ, new cities, new industrial zones are planned and developed for. Tall and lavish buildings are constructed.
• Housewives become active in the stock market. People tend to give up full time jobs in order to concentrate playing the markets. New breed of young investors tend to perform better than the seasoned money managers and talks about winning stock market formulas

Generally in this phase even after a sharp decline and major shock, the mood remains optimistic and they tend to buy on decline. Capital loss in first decline is not serious and thereafter further declines put systemic strains and serious havoc among varied class of investors and speculators

Phase four starts thereafter with financial strains. Leveraged speculators are forced to sell. Lending standards are tightened and bad loans begin to climb. Tourist arrivals slow and hotel occupancy rate declines. Brokers continue to publish the most bullish reports arguing of a life time opportunity. Finally political and social conditions deteriorate. The recovery in the phase four happens with selected stocks and sectors, taking the indices higher closer to all time highs or may even conquer it with thin volumes and narrow advance/decline ratio. The powerful recovery generally tends to seduce investors and speculators. Economy continues to do well after a brief pause and corporate continues to post profit growth though the intensity and pace declines significantly.

The transition from phase four to phase five is passive with no major knee jerk reaction. Rather a drifting lower kind of market with symptoms’ such as falling GDP, unfinished construction sites, higher budget deficits, stock brokers laying off staffs or even close down and research reports becoming thinner. Country no longer remains a favorite tourist destination. People generally tend to realize their follies and give up on stocks and any rallies are perceived as an opportunity to sell at the end of phase five rallies and in the phase six.

Phase six becomes the actual climatic phase where interest rate is perceived to hit trough. Negative headlines rules the media, currency weakens considerably on current account imbalances and fiscal deficit burgeoning. Flights, hotels and nightclubs are empty, foreign brokers turns bearish and shut shops. Volumes decline sharply and mutual funds corpus decline with persistent outflows. Post a panic selling or a capitulation on depressed economic and political environment, stock price reaches historical low valuation and negative news doesn’t affect the prices much and hence prices no longer declines and start building base for a next wave of bull market.

The Boom and the error of optimism give way to a crisis of confidence and fear, the error of pessimism.

Identifying the Climatic Phase

As far as Indian market goes, it’s clearly evident from the symptoms in 2006 and 2007, that final run-up to 6300 in Nifty was a phase three phenomenon where money making was quick, volumes were huge and sentiment run euphoric. Thereafter with the massive fall and the bubble burst, led  us to phase four with fewer stocks reclaiming their all time highs by 2010 and indices almost retesting it’s life high. After phase four with market almost kissing 6300 in Nifty, phase five culminates in 2011 with the whole year seeing a worsening of sentiment with scams, slowdown in the economy, interest rates reversing its trend and starts declining, brokers laying off big time and many foreign brokers shutting shop. Phase six generally coincides with further worsening of sentiment and capitulation. Phase five and six are quite tricky in a sense that when phase five converts into phase six is difficult to identify. Phase six generally is the mirror image of phase three. Generally in phase five brokers lay off  employees, leveraged companies resort to fire sale of their assets and depress share prices further, corporate profit deteriorates as had been seen in 2011 and in phase six currency weaknesses reaches a climatic stage, interest rates hits a trough. At present with a series of reforms in India, INR has reversed its trend after hitting 57.32 but interest rates still not hitting trough with repo hovering at 8 %( last registered trough was at 4.75%). Phase six till now has not been clearly evident and a capitulation haven’t happened in any meaningful way and complete. Though the confusing part is that stock specific capitulation has happened and in dollar terms index have declined 40% in 2011. Moreover Political chaos generally continues in phase zero and currency continues to remain weak in this phase with high inflation. So clearly one can construe that we may be meddling between phase six and phase zero and we can conclude the ending of phase six once the interest rate declining cycle gathers momentum and come closer to the troughs and valuation starts looking cheap…

Longterm Economic Cycles with Four phases- Innovation, Growth Boom, Shakeout & Maturity Boom along with demographic spending wave cycles and preference of investment class at different phases

Paras Bothra

paras.bothra@ymail.com

+91 9831070777

Power of Globalization & Market Outlook!

In the 19^th century, the Western power colonized countries with guns, today they do it with McDonalds, Coca-Cola, Starbucks, Hollywood, CNBC, CNN, BBC, Bloomberg, Reuters, Gucci, Armani, Wal-Mart, Reebok, Adidas, Omega, Gatherer, BMW, Mercedes ; massive capital flows at high interest rates, and by doctrine that open markets will automatically lead to prosperity. 

*German ratification of ESM

*QE3 by Federal Reserve of US

*Diesel price hike by Rs5/- and putting a cap on number of subsidized cylinders

*FDI in Multi-Brand Retail, Aviation, Broadcasting, Power Exchange

*Disinvestment in four PSU’s

*Political chaos with TMC withdrawing support from UPA-2

*RBI cuts CRR by 25 basis point

*Withholding tax on interest payment of foreign loan reduced from 20% to 5%

*Rajiv Gandhi Equity Scheme to increase retail participation

*SEB’s debt restructuring of 1.90lac crores

*United Spirits in talks with Diageo

The more the world changes, the more it remains the same. Societies rise and fall; new industries come up and then fade. Wealth accumulates, only to be destroyed. People live longer, but their suffering when sick is prolonged. Wars may not be fought with huge armies facing each other in trenches but through terrorism and with trade embargoes, holding off supplies from the market (oil cartels), defaults on foreign debts, expropriations, computer viruses, etc. And while, in the 19^th century, the Western power colonized countries with guns, today they do it with McDonalds, Coca-Cola, Starbucks, Hollywood, CNBC, CNN, BBC, Bloomberg, Reuters, Gucci, Armani, Wal-Mart, Reebok, Adidas, Omega, Gatherer, BMW, Mercedes ; massive capital flows at high interest rates, and by doctrine that open markets will automatically lead to prosperity. 

We are firmly entrenched in a capitalist economic system and after the dismantling of the Soviet Union communisy economy in the 1990’s, the world is completely ingrained with a system where globalization has put forth varying degree of opportunities in terms of cost arbitrage, labor arbitrage and various other economic prospects. Indian pharma companies in the last decade started producing generics and bulk drugs for exporting to developed countries because the manufacturing cost of Indian pharma companies is around 65% of the US firms and almost half of the European manufacturers and thereby generating dollar income. Information technology flourished in the late 1990’s with the opening up of the sector which generated huge dollar earnings and employment for a different class altogether.  These sectors with skilled workforce have established our credentials in global product/service delivery mechanism.

Likewise in a globalised economy if we can export products and services to global markets then why can’t we allow global players to come with capital and expertise to set forth an efficient business model which will open up a vast array of ancillary business opportunity, employment prospect and economical shopping experience for the people of India?  FDI in retail is going to be similar to IT and Pharma which will put us one step further in league of prosperity. FDI inflows could be huge with the floodgates opening for foreign giants like Wal-Mart, Carrefour, Tesco and many others. There has been a lot of noise for opening up of the sector, but the question remains that who is shouting against it? It’s the politician who in the name of saving the common man, kirana shops, hawkers, mom & pop stores, middleman, is willing to take a political mileage by gaining vote banks.  But no one is talking about the fact that the cost competitiveness will drive prices lower and ultimately benefit the consumers in a big way. Overall employment creation could be 4 million direct jobs and apprx 6 million indirect jobs in next 10 years.

Because of various formats of retail i.e., supermarkets, hypermarkets, shop-in-shop, departmental stores, franchise model, convenience stores,  not only does the price inflation come down but it will also change the shopping experience in India. Biggest improvement will be in the retail infrastructure, i.e., logistics, warehousing etc.  At present in India one major cause of food inflation is the pilferages of the food in warehouse to the extent of 30% to 40% and this clearly indicates that how much India is under invested in its infrastructure. FDI in retail is certainly going to fill these gaps and lapses in retail and at the same time eradicate middleman in the supply chain system and bring down cost of goods with bulk purchases. All these are going to be beneficial for Indian consumers. Moreover Indian retail industry is at present a USD ~435-500 billion industry and in next ten years it will hit USD 1trillion and such a large scale market is bound to accommodate many players and small shops to co-exist.As per PWC, the Indian Retail Industry is pegged at US$ 500 billion and is expected to reach US$ 1.3 trillion by 2020. In addition, the organised retail is expected to reach 25 per cent by 2020. At present the organized retail market is almost US$ 35 billion. There are estimates that India’s organised retail market could attract US$ 15 billion in the next three years. Opportunity remains considerably big in organized retail.

In recent days a totally new economic lesson has emerged, the so called conundrum of de-leveraging by the private sectors and on the other hand huge liquidity infusion by the central banks are exerting powerful asset-price rallies around the world.  The problem with credit/liquidity driven expansion is that credit growth must accelerate continuously for the economic plane to stay aloft. The moment credit growth slows, liquidity and solvency problem arises. These are undoubtedly extraordinary times when there in zero interest rates in developed markets staying for a considerable period of time, ten year govt. yields and corporate yields are at record low level and investors have no other options except to buy equities or higher yielding assets of the emerging markets. People are searching for growth stocks and high yields and credible stories in emerging markets are finding buyers. Economic growth story has wide divergence and is unsynchronized unlike the 2002-2007 phases and every economy has a wide array of its own internal problems to deal with. Financial markets have become a considerably powerful tool in sparking hopes of revival globally and the up moves are termed as “risk-on rallies”. Fiscal cliff is the next global theme which surely the market would start talking about once the presidential elections in US is over.

In India as well capital formation has considerably slowed down in recent years specifically from the private players because of high leverages in hey days of the booming economy. And to make the matter worse, opening up of the scandals has completely shaken the decision making process of the government and the corporate as well. Coupled with it, high inflation and interest rates are putting enormous pressure on the corporate profitability. Recently with the kind of big bang reform announcements, sentiment has improved for the better and now interest rates and inflation needs to come down sharply so as to stimulate the investment cycle which will lead to creation of capacity and a revival of economy. 

All through this phase of uncertainty, one noticeable trend is the corporate India sales numbers which continuously remained elevated since 2009 despite the fact that GDP numbers are slipping thick and fast. For the corporate sales number and nominal GDP, justification could well be given from the fact that inflation remains high and so the sales figure includes the price hike. Despite of higher sales, baring FMCG and Pharma and other defensive companies, pricing power remains very low and interest burden and depreciation for ongoing projects eating into the bottomline and hence profitability steadily declined in 2011. Since the year 2000, there have been two instances when sales dipped sharply and hitting rock bottom was in 2002, 2009 and negative profitability growth was in 2001,2009 and 2011 and at the same time marking significant bottom in the Sensex during those phases. Though this time around in 2011, the PAT decline was sharper than the PBIDT despite the fact that sales remains elevated at 15% to 17%.   Reasons for the divergence are because of leverage in balance sheet and higher depreciation due to capex burden initiated a couple of years back.

It seems that the economy needed a trigger for improvement of the general business climate and last month was historic in every sense with the way the government came out with bold measures highlighted above. First the ECB and FED QE3 announcement of bond buying programme and there after the momentum carried forward with big-bang pending reforms and finally TMC withdrawing support and SP coming in was well taken by the markets and it zoomed up almost 6% in September series.

For a market trend to reverse and embark on a journey of structural uptrend requires

1. Earnings growth to support valuations

2. Liquidity to revive investment spirit

3. Yield curve to steepen

4. Current Account Imbalances starts showing signs of improvement

5. Pessimism all around with strict denial of an economic uptrend resuming

These factors encompasses all the essential ingredients of a bull market, whether a mini bull market or a secular uptrend. Till now valuations for Indian markets were below historical averages and a mean reversion trade was predominately the theme to buy under valuation and sell at a mean valuation. Secondly, liquidity remains abound with central banker’s expansionary monetary policy and Indian liquidity tightness gradually easing off.  Thirdly, Yield curve to steepen to confirm an economic recovery. At present the yield curve remains flat with no difference in short-term and long-term interest rates, is indicative of the fact that economy is experiencing a slowdown. Though we would argue that the market identifies an economic recovery well in advance but still interest rates declines should have precipitated a long way closer to the historical trough, before an economy reversal is called for and a yield curve steepening thereby indicating a recovery underway.  Fourthly, it is perceived that Current account deficit likely to improve with crude oil price correcting on fundamental grounds and import bill declining in coming months on back of INR appreciation. Finally, Pessimism all around was prevalent in 2011 when market marked a bottom around the 4500 mark in Nifty and thereafter making higher tops and bottoms. 

Now the capex cycle needs to turnaround and GFCF (Gross Fixed Capital Formation) should start building up to mark a firm recovery backed by investments and triggered by bold reforms and policy decision by the government. Pieces have started falling in place and we need to see more of it…..

Paras Bothra

Email- paras.bothra@ymail.com

Ph: +91 9831070777