Why this market fall is a correction and not a bear market and why does it matter?
Why are we asking this question? Why does it matter at all? Shouldn’t one sell if markets are going to fall? There are many definitions of the terms ‘correction’ and ‘bear markets’. It is important to distinguish between the two to better strategize.
If we were to chart the history of the Indian equity markets since 1979, we would note 16 instances of 10-30% declines that lasted over a 3-9 months’ timeframe, these I would categorize as correction. There are however only 6 instances where we witnessed a decline of more than 30% which lasted for more than 9 months and these I would categorize as Bear market. As we speak, markets have already corrected close to 20% from its peak of 9100 and we are into the 6th month of downtrend. It would be prodigious to be able to take a cash call every time the market was about to see a 20% drop. We, however, believe it is almost impossible to get the timing of all of the declines spot-on. The real bear markets are fewer and it is much more productive to call those. Those are the ones we aspire to get right.
The fallacy of the narrative of “Acche Din”
What is a narrative? It is the story that investors tell themselves based on which they take their investment actions. During the campaign of 2014 Lok Sabha elections, BJP coined the phrase “Acche Din”. So phenomenal was the success of this phrase that it instantly struck a note and is yet fresh in all of our minds. Problems arose when people started applying the narrative to their daily lives. Most of the voters are probably more liberal in their interpretation and timeline for the arrival of acche din. But, Equity markets being what they are can only interpret it in binary manner. Markets going up = Acche Din, Markets going down = No Acche Din.
It is not our objective to interpret whether “Acche Din” have arrived for voters or for any other segment of the society. Our objective is strictly restricted to the extent of Indian equity markets. To be able to understand whether this is a bear market or a correction it is important to understand the drivers of the same. Every prolonged market trend has its genesis in some fundamental characteristics. Once the driver of the trends have played out or if the valuations have reached extreme that is a time that one should be worried about serious wealth destruction.
1997 – 2000: Rapid growth in IT with the onset of internet, computing, Y2K drove the DOTCOM bubble which in turn drove the outsourcing boom in India.
2001 – 2003: It was a correction of extreme undervaluation, where 10% dividend yield was the norm.
2003 – 2007: We saw a heady growth phase with growth in asset heavy industries being fuelled by debt, quasi debt and equity dilution.
2008 – 2011: Reversion to mean, as economy had not deteriorated as much as the markets. In addition, response of global central bankers to the crisis was more stimulus and liquidity.
2011 – 2015: Usually bull markets are driven by falling interest rates and pickup in economic growth. But this bull market has not been driven by either. In our opinion, it’s a trend driven by improvement in ROE. It has been a phase dominated by survivors and market leaders. Businesses with a differentiated product, or expanding into newer markets have done well. Drivers of ROE’s have been cost-cutting, expanding market share, falling input costs, judicious use of capital. In other words, going has been tough and only the tough got going. The usual rising tide lifts all boats have been missing. Because it is still a receding tide. Businesses and promoters that have been swimming naked are in full view of the market.
Post May 2014, the popular narrative believed by the market participants was that we are entering an era of economic revival due to the arrival of the new government at the helm with an unprecedented majority. The market participants that did place their bets based on such a narrative, find themselves the most disappointed with the revival of the economy taking longer than expected. Worsening of NPA cycle, China slowdown, real estate slowdown, rural economy slowdown further accentuated by retrenchment in parallel economy has actually completely washed away the economic revival narrative. Contribution of stocks representing this narrative to the market returns has been negative post-election results and it got further accentuated in the current downtrend. This is not to say that this narrative is not going to pan out. Probably, this is a good time to be a contrarian and give it some serious thoughts. The key however, lies in understanding the pace of economic revival, pace of reforms, areas of revival and pace of fall in capital cost.
If this is the beginning of a pro-longed downtrend, what could possibly be the drivers of this trend? (Note: This is not an exhaustive list, just the common narratives found in market commentary)
Chinese slowdown has been the reality before its equity markets started cracking. Electricity consumption in 1H15 grew by only 1.3% vs. an approximate growth rate of 5.5% seen in the first half of 2014, 2013 and 2012- this in itself is a simple illustration of the Chinese slowdown. Fall in Input costs also have been indicating Chinese slowdown. Given that India competes with China for raw materials as well as fund flows, the slowdown is a net positive for India. There are however a few pockets that will be hurt such as the raw material exporters that see China as a trade partner. (Ref Table 1).
It is however important to note here that China is currently characterized by an industrial slowdown. The consumption portion of the economy, albeit a small part, will continue to grow; especially with renewed government focus to drive consumption. Indian exporters of finished goods and branded products could therefore see China emerge as a potential market.
Global deflation scare
Falling raw material prices have led to disinflation globally which has sparked off a deflation scare. This we believe will compel central banks to continue to pursue their dovish strategies to revive their respective economies. All of this liquidity will find its way to stronger and improving macros. India will stand out as a destination for the same once the dust settles.
US rate hike
Chances of a 25bps rate hike by the U.S.Fed in September nose-dived with jittery global markets and weak jobs data of the past week. However, what really matters is the policy stance adopted by the Fed subsequent to the 25bps rate hike, which we believe will continue to be dovish. Central bankers spent Central bankers from US, Europe, Japan and China have been following loose monetary policies to lift economic growth. Fear is that if global growth does take a nose dive again then central bankers have no tool left to revive the economy. India on the other hand has been preserving its firepower. India has erred on the side of caution with expanding its balance sheet. India’s government finances are on the mend. Here also, India stands out from the world.
Implications for India?
As discussed above, Chinese slowdown or a deflationary scare is a net positive for India. Indian economy can remain an island of positive out performance. We live in a world of connected flows governed by international factors and hence Indian markets will surely get impacted in the short run. It would therefore be foolhardy to believe that we would not witness any collateral damage in the Indian markets. How much and how long is the question. It is important to remember that India is the collateral damage and not the eye of the storm. Once the storm passes and the dust settles, India should emerge a stronger economy. A strong and decisive government along with a prudent central bank that ensures a strong balance sheet for the country will make us ready for growth once these headwinds in the global markets pass. In the meantime, extreme valuations in quality and growth are cooling off, offering even more compelling entry points to own a good business.
Overestimation of domestic recovery and accentuation of problems in domestic financials due to the delay of recovery are problems caused more by the excesses of 2005-2007 rather than new problems created post 2009. The markets have recognized these excesses completely, as is palpable from the gross under- performance of the real estate, metals, utilities sectors compared to the broad indices and other sectors. (Ref Table 2).
Is this is a serious market top (a.k.a 2000 or 2007)?
India is the collateral damage in the current global storm however we hardly believe that the high seen prior to the current fall is a serious market top that cannot be taken out for a few years. The following are some of the indicators which would usually suggest a serious top in the market. Some of these conditions may or may not exist in the global markets but we don’t believe that any of these indicators characterise the recent highs in the Indian equity markets.
Rapid growth in fund raising
The trend in equity issuances suggests that the market are currently nowhere near the euphoric state of 2007 (Ref to Fig 1 and Fig 2). Driven by Reliance Power, fund raising by domestic IPOs surged in FY2008. The number of issues too started rising with the progression of the bull market, peaking in 2007. We are currently nowhere near to seeing those characteristics in the equity markets.
Extravagant capital allocation decisions, diversification and outsized acquisitions
As a precursor to the financial crisis of 2008, we saw a flurry of large scale M&A deals being closed. Tata Motors bought JLR for $2.3 billion, Hindalco purchased Novellis for $5.9 billion, and Tata Steel bought Corus for $12.2 billion amongst many more. The total quantum of the M&A deals signed by Indian companies rose to $33.1bn in 2007 from $15bn in 2006 and $4.3bn in 2005. These transactions tested the strength of the companies with most deals outsizing the balance sheet. Still reeling from the excesses of 2007, we do not see such M&A yet.
Extreme retail participation
The classic example of this would be the Reliance Power IPO in Jan 2008, Biggest ever IPO of the time. FIIs oversubscribing by 82 times, HNIs by 163 times and retail investors by 15 times. Brokerages complained of running out of new demat account forms with the surge in account openings in order to subscribe to the IPO. We do not see any such exaggerated IPO issues and retail participation right now.
The government’s balance sheet continues to strengthen with the government debt to GDP ratio declining.
Before the 2008 market crash, the market capitalisation to GDP ratio rose to 103. The recent highs had taken this ratio to 79. The pockets of stretched valuations that we saw within this market within “quality” and mid-cap stocks seem to have corrected for the most part bringing the Market Cap to GDP ratio down to 69.
Usually, serious market tops are associated with scores of anecdotal evidence of euphoria across general public. Neither newspaper headlines nor retail participation suggest an over optimistic outlook of the public. Prior to the 2008 crash, we see a surge in the google trends index for the word ‘SENSEX’ in India. A google trends index shows “how often a particular search-term is entered relative to the total searchvolume”. The index below shows a rise in 2007 making a peak in Jan 2008 prior to the increased searches we see during the crisis itself. This itself depicts the over involvement of the public in the markets pre the financial crisis of 2008-09. This is visibly not the case right now.
Why a pullback was par for the course?
Overestimation of recovery
Many investors and onlookers bet on India’s immediate economic revival with the election of the new government with an overwhelming majority. There was an onslaught of high GDP growth and company earnings estimates. The recent pullback has tempered expectations. Moody’s revised FY16 GDP growth estimate to 7% from 7.5% and Fitch to 7.8% from 8%.The consensus SENSEX EPS estimates for FY16 have been revised down from Rs. 1750 (in April 2015 to approximately Rs. 1530 post this earnings season. We see a similar revision from Rs. 2100 to Rs. 1900 for FY17 earnings estimates.
Complacency in highly valued stocks
In the last year we saw investors being complacent and flocking to the popular “high quality” stocks leading to stretched valuations for these stocks.
Deteriorating global environment
The recent actions of the Chinese government in order to engineer a soft landing have made its slowdown apparent to the global markets. The moves in commodity prices itself are evidence enough to illustrate this industrial slowdown. Economies such as Brazil and Australia, that rode this growth trajectory with China by exporting raw materials to the Chinese, face a slowdown themselves. Extent and pace of slowdown seems to have worsened.
Lots of moving parts in currency and bond markets
Following the decline in commodities markets, we noted an increased volatility in currency and debt markets. While the EM currencies tumbled, Euro and the Japanese Yen made gains against the dollar. The events of this week have reduced the probability of a rate hike by the Fed in September which could result in sustained volatility in the currency markets. The bond markets too have been very volatile, with trends reversing in the major 10yr yields, April onwards. The volatility in these markets resulted in increased pressure on many of the foreign portfolios, consequentially resulting in India being the collateral damage in this storm of changing flows.
6 year uptrend in developed markets with no major correction
The dominant developed markets such as the U.S. and Germany have seen a consistent uptrend from the 2009 lows with the exception of a correction during the 2011 euro crisis. These markets were therefore due for a pullback with India being collateral damage due to connected global flows.
Why India’s bull market will continue?
With valuations no longer being super demanding we believe that India has the structural elements in place for the equity markets to remain bullish.
Recovery delayed, not denied
Investors that remain most disappointed in the market today are the ones that have placed their bets on the new government jump-starting the recovery. Economic revival though delayed, is bound to germinate given the favourable trends in the economy. Whether it is 2HFY16 or 1HFY17 is the only question in our mind.
Crude windfall: A shift from $100/bbl oil price reality to the $50/bbl oil price environment will result in annual savings to the tune of $70bn (approx. 4% of GDP) for the Indian economy. A fall in commodity prices has also led to inflationary expectations in the country to recede.
Front loaded capex: Government spend on capital in railways, roads, defence, etc. sectors is gathering steam. A first in its history, the Indian Railways released their quarterly numbers for the June ending quarter. In Q116 itself, the transporter reported a staggering 134% jump in its capital expenditure to Rs. 17,734 crores. Of the Rs. 82,000 crores approved for the dedicated freight corridor, Railways has already floated tenders for over Rs. 19,000 Crores. Until July, the National Highway Authority of India (NHAI) had put up projects worth Rs. 48,000 Crores for bidding.
Improved government finances: The windfall from lower crude prices along with systemic changes in spending programs such as subsidies, has aided the government to contain fiscal deficit at 4%, beating its own target of 4.1% and the previous year’s deficit which stood at 4.5%. The government expenditure on subsidies has come down to 2% of GDP from 2.2% in FY14 further aiding this fiscal consolidation. Structural factors remain intact India has a growing, young population. An estimate by United Nations suggests that India would provide an additional 124 million people to the global labour pool by the end of 2025. This is far greater than the 12 million to be contributed by China, 5 million by USA or the 28 million by Europe. This demographic dividend along with a stable government in the centre with resources to spend, will sustain India on a growth trajectory.
Alternative assets peaked out
The financial crisis of 2008-09 caused Indian households to increase their savings in physical assets such as gold and real estate. This trend peaked in FY13 with roughly 70% of the household savings being parked in physical assets. As inflation rates continue to decline, the real rate of return on financial savings will rise, convincing households to deploy a larger chunk of their household savings in financial assets.
Flight of foreign capital is being matched 0.8: 1 by DII’s. Furthermore, more of the household savings will be directed towards financial instruments and eventually equity will see a rising allocation domestically. We believe this is a beginning of a trend as seen in the chart below.
Factors impacting ROE still show a favourable trend
Interest rates: The RBI has already instituted rate cuts of 75bps since peak. With inflationary pressures cooling off and the rupee staying relatively strong amongst other EM currencies, we will see more rate cuts being implemented eventually.
Gross margins: This earnings season has demonstrated the gains in gross margins for many. With commodity prices continuing on their downtrend due to a Chinese slowdown, we could see a further improvement in gross margins.
Deleveraging: Some of the companies which suffered from the excesses of 2007 are now able to deleverage and clear their books.
Downtrend we are witnessing in the markets is corrective in nature is what we conclude from our analysis. Price correction can range from 20 – 30% and it can last for a period of 6 to 9 months. One should use these externally induced volatility in markets to increase allocation to Indian equities. Since economic environment is till deteriorating, stock picking will remain the key.