"till the time perception doesn't changes into a consensus the rally will keep building up year over year amid bumpy rides. And a phase comes when macro economic data catches up and starts justifying the prices and convinces even the dumbest person on earth that the economy is on a strong footing, as a result of which retail participation starts increasing and volumes starts gaining traction. And a strong indicator of a perception building into consensus is the newspaper headlines and electronic media making bullish commentary and thereby sucking in more retail and hot money. A herd mentality starts building up and thereafter we know the consequences! At first it will just be a trickle. Then the trickle will become a stream. Eventually, the stream will become a river and finally a flood. These all phenomenon takes its own sweet time to fructify, probably a couple of years till we reach the climatic stage. What I am trying to highlight is the fact that rally in equity market is build up on behavioral finance and expectations and later on fundamentals. Economic indicators are a poor tool and a distinct lag indicator to judge the direction of the market and there has always been a stark disconnect between the equity market and the GDP growth."
We are at an interesting crossroad where on one side the bulls justify the unfolding of a major up-trend on optimism of an improving economic outlook despite of bad macro indicators and the bears keep singing the tune of a collapse any time soon as the rally is not supported by strong fundamentals. And if we hear the commentary of both bulls and bears, it’s the negative commentary which will look more convincing. The economic data as it stands now truly reflects the same, not only in India but across the globe. Then despite of it, why the markets are showing a great disconnect from the real economic state? If we read the history of financial markets, we will come to know that the GDP growth rate doesn't have a mindful impact on the equity markets, otherwise Chinese stock market should have been at a multi-year high. Despite of a slowdown, the Chinese economy is growing at a speed which is relatively unmatched in the global context. But the fact remains that China is far below its historical highs in comparison to other emerging market peers like India and developed markets like US to name a few. If the economic indicators have had any meaningful influence on the global equity markets, we should not have seen equity markets world across registering good gains last year.
If we specifically look at India, it’s amazing to see the market scaling heights at a time when the real GDP is hitting 5.3% growth in September Quarter, which we haven’t seen for a long time. All macroeconomic indicators and others, whether we take current account deficit, fiscal deficit, political instability, scams, interest rates, high inflation, GAAR issue, corporate profitability or capex cycle, its all hitting straight at the face of the equity market and such dire economic conditions should have potentially blown the lights off of any bull rally emerging. But the equity markets choose to behave the other way round. If you start analyzing the equity market, you will find number of easy reasons for why the rally should terminate at this juncture but you will find very few sound and strong reasons for a secular bull market and a new all time high. Yes, of-course the most strong bull case could be concluded by most of the market savvy investors is the fact that liquidity remains extraordinarily strong because of Helicopter Ben’s QE’s or Europe’s LTRO or for that matter latest in the fray is of Japan targeting 2% inflation and stimulating its economy with massive money printing. Domestically, reforms kicked in by the UPA-II have strongly helped in supporting the bull case, but the market started marching much ahead of the reform process. But most Bulls out of experience are being noticed as perennial buyers in any given condition and a different breed who can even justify the worst of economic indicators being factored into the price and hence things to improve. They can even justify with the fact that despite of GDP slowdown, there are companies who can sail through tough times by managing their resources exceptionally in India and downsizing their expenses to generate profit even in tough times.
But to my mind, it’s the perception and expectation of earning cycle which decides the fate of markets. Expectations usually remain abysmally low at the early stages of a bull market and hence valuation remains historically low at this stage. Otherwise how a market is about to hit a new high despite of all macro variables remaining weak and real GDP growing at a snail’s pace. When you hit the rock bottom, the only way is the up-way. Macro economic factors once worsened will take time to recover and come back growing, but the perception gradually changes with the fact that coming quarters and years could not be as worse as it is today and market starts building gains on expectation despite of bad news floating. Any untoward incidence knocks back the market, but till the time perception doesn't changes into a consensus the rally will keep building up year over year amid bumpy rides. And a phase comes when macro economic data catches up and starts justifying the prices and convinces even the dumbest person on earth that the economy is on a strong footing, as a result of which retail participation starts increasing and volumes starts gaining traction. And a strong indicator of a perception building into consensus is the newspaper headlines and electronic media making bullish commentary and thereby sucking in more retail and hot money. A herd mentality starts building up and thereafter we know the consequences! At first it will just be a trickle. Then the trickle will become a stream. Eventually, the stream will become a river and finally a flood. These all phenomenon takes its own sweet time to fructify, probably a couple of years till we reach the climatic stage. What I am trying to highlight is the fact that rally in equity market is build up on behavioral finance and expectations and later on fundamentals. Economic indicators are a poor tool and a distinct lag indicator to judge the direction of the market and there has always been a stark disconnect between the equity market and the GDP growth.
It is the expectation of the pace of growth in Corporate earnings, which decides the stock prices and the P/E multiples and other valuation metrics. In a bad economic phase like the one we have seen last couple of years, causes low expectations which finally culminates into lower valuations for equity as an asset class. CAGR growth in Sensex EPS from FY-08 to FY-13 (5 years of low growth in earnings) has been at 8% and in comparison to it when the Sensex had stupendous bull market from FY-03 to FY-08 (5 years of earning expansion) the CAGR growth in EPS was at 25% after which the great financial crisis in US punctured the synchronized bull rally in global markets. Growth in earnings is the greatest driver for markets and expectation of it drives the prices higher and expand the P/E multiples to stratospheric heights even before the earnings growth is registered. Sensex CAGR EPS growth during FY-93 to FY-96 was at 45% and thereafter a long dry spell of a CAGR EPS growth of 3% was witnessed from FY-96 to FY-2003 (for almost 7 years).
|
Period
|
Sensex EPS Growth (CAGR %)
|
Sensex Return (CAGR
%)
|
Average GDP Growth Rate (%)
|
|
FY1993-1996
|
45%
|
21.5%
|
6.8%
|
|
FY1996-2003
|
3%
|
-1.6%
|
5.3%
|
|
FY2003-2008
|
25%
|
50.5%
|
8.9%
|
|
FY2008-13E
|
8%
|
6.5%
|
7.3%
|
Recently, in India, if we try to gauge the sentiment of the market and the participants we will find that though we are at a kissing distance from an all time high, the rally is becoming narrower and there are few stocks which are keeping the Nifty afloat at such high price levels. Retail participation is practically negligible and neither are they convinced enough to put money into equities yet. More to their disenchantment is the fact that virtually most of the midcaps are closer to their all time lows and some of them are even registering newer lows and high quality stocks with sound financial metrics are beyond their reach. Moreover higher inflation is eating into their income and hence allocation to equity remains low at this point in time. They will probably come in once their income level starts rising and market hitting newer highs and most importantly midcaps starts moving with break-neck speed. Low retail participation in the market is generally an indicator of low return expectation from the retail investors and is generally good for the long-term health of an emerging bull market which is low profile at its early stage.
One striking thing which has been noticed is the fact that top corporate executive of many companies also projects a pessimistic picture at a time when things are already bad and capex building remains cheaper. But most of the companies would probably be coming and committing large projects once the economic data reflects resilience and market is at its top in a few years from now. Very few smart entrepreneurs would be busy building up here….
RBI, finally cutting Repo rate by 25 basis points and CRR by 25 bps on back of moderation in growth outlook, inflation peaking off, and consumption demand starting to decelerate. RBI’s Dr Subbarao guided that further monetary easing to happen if Current account deficit abates and inflation moderates. RBI finally is changing its stance to promote growth and anchor inflationary expectations rather than its earlier hawkish stance to fight inflation in isolation. Substantial easing of core inflation suggesting inflation has come off its peak. GDP growth projections have been scaled down to 5.5% from 5.8% projected earlier. Inflation estimates have also been scaled down to 6.8% from 7.5% projected earlier. Non-food manufacturing products prices have eased off but food article prices still remains a sticky issue for households. CRR cut was primarily to enhance banking liquidity to spur credit growth in an otherwise flagging economy. It is clearly evident from the recent action and changing stance of RBI is that it is more reactive to the set of economic data rather than proactive and hence RBI becomes an extremely lag indicator in signaling economic trends. Though elevated interest rates for a longer period has done one good thing to INR is its appreciation in recent months. Higher interest rates leads to foreign funds flocking to Indian shores for higher yields and thereby rupee appreciating on back of foreign fund flows into India.
Lowering of inflationary expectations along with growth flagging would certainly bring down interest rates and hence spur growth and support earning momentum. Expectations of declining interest rates always improves the earning yield to bond yield ratio and thereby re-rates equity markets as a better place for higher returns compared to fixed income groups.
Paras Bothra
+919831070777
