Global markets have started the year with perhaps the worst performance in over two decades. The sell-off has prompted commentary in the media “hinting of parallels with the 2008 like crisis”
Is this 2008 once again? Should one exit the markets, or grit our teeth and stay invested because we should have a “correction” rather than a deep “sell off”?
Our analysis suggests that there is a strong case for Indian investors to remain invested as the data does not suggest we face a 2008 like situation
• Entry valuations are by far the dominant variable in influencing market returns. Even when the macro has been unfavourable, but entry valuations reasonable, Indian markets have delivered strong returns over a rolling 3 year horizon.
• The years of significant poor returns (>15% annual decline in equity markets) in the last 16 years have both been associated with an external shock AND unfavourable valuations when the shock hit.
• Entry valuations in India are not unfavourable at present, especially keeping in mind that corporate profit margins are at a 15 year low. With the boost to margins from collapsing commodity prices, margin expansion is on the cards. This should support earnings even if volume growth is illusive
| India: Valuation parameter | Jan 2008 | Jan 2016 |
| Market Cap to GDP | ~125% | ~72% |
| Trailing PE (NSE Website) | 27.9x | 20.5x |
| Corporate Profit to GDP | ~7.8% | ~3.9% |
| Yield Gap (10 Year GOI Bond Yield – 1 Yr Forward Earnings Yield) | 3.2% | 1.8% |
One however, needs to be prepared for a correction
• India never remains immune to Global sell offs.
• Valuations in other markets example the US are well above fair zone and offer no margin of safety at present. In fact, the fall in prices being witnessed at present can also be attributed to concerns on earnings growth in the US with margins at peak levels; bankruptcy concerns of highly leveraged Shale Gas explorers; these concerns have got heightened by fears of a deeper slowdown in China and the perceived incompetence of Chinese authorities
| US: Valuation parameter | January 2008 | January 2016 |
| Market Cap to GDP | ~ 110% | ~125% |
| Trailing PE | ~25x | ~21.5x |
| Corporate Profit to GDP | ~8.2% | ~9.9% |
• Paradoxically, events that should benefit India, example a selloff in Commodities/Crude Oil, actually hurt Indian markets in the short term as they commence a Global “Risk Off” trade and result in FII Selling.
• Commodity exporting countries are facing significant pressure to balance their budgets and deliver growth. Sovereign Wealth Funds will therefore sell stocks to help fund national budgets. In times of crisis, you sell what you can sell, not what you would like to sell. Indian stocks owned by SWF will therefore face selling pressures.
Our assessment that one remains invested in Indian Markets is further supported by the following arguments
- India Growth is clearly weak vs expectations. However, one must look at growth in the context of a very challenged export environment and Govt. crackdown on corruption. Credit growth is partially depressed due to collapse in Commodity prices and especially Oil, as that has reduced need for Working Capital loans; two back to back poor monsoons, and cut in Minimum Support prices for crops have impacted demand from Rural India. However, none of the above is a structural slowdown.
- Inflation, and Current A/C deficit – are all in comfort zone.
Government has room to pump prime the economy from savings from Crude Oil to the extent of USD 30-45 Billion. Every USD 1/barrel drop in Oil saves the economy USD 1 Billion. Some action is already visible, specifically on Roads.
- Despite delivering about 7% GDP (per perhaps 5-6% if we believe the doomsayers), India is a growth haven at present. Typically, Capital chases growth. At some point in time, FIIs will start differentiating between markets.
Global risks – geopolitical, economic, etc. – are openly being discussed and hence a lot of the negatives should start getting priced in, unlike in 2008, where very few people saw the impending crisis.
• 80% of stock price movement happens on 20% of the best trading days. If one misses the large positive moves, overall returns will be significantly affected.
• Domestic investors continue to be robust investors in Indian equities having infused more money in the market in the last 18 months than cumulatively in last 10 years
• Central Banks are very deeply invested in their strategy to boost Asset prices. The Chinese and Japanese Central Bank are even supporting their equity markets by direct purchase of shares. There is no reason to believe at present that this strategy would not continue to be supported even more strongly if markets were to slide.
Readers are however warned a tail risk event will certainly impact India.
• Between April 2008 and March 2009, our FX reserves fell by USD 58 Bn (from 14.5 to 9 months of import cover), despite a favourable macro-economic environment at the start; the markets returned -35% that FY.
• When tail risk events hit, all bets are off because there is panic selling for the exit.
• However, the timing of Tail risk events cannot be predicted; they only need to be planned for via Asset Allocation
How should one position portfolios?
• Remember CY 16/FY 17 promises to be a volatile year; and that markets can be irrational for a long time.
• Also remember, the principal factor determining returns is investor behaviour (not the choice of fund manager)
• Asset Allocation is key. One should be mentally prepared not to sell out of panic. It is better to sell some equities now and wait on the side lines if you cannot handle volatility. Any cash requirements for the next 24 months should not be in Risk Assets but held either in Liquid Funds or FDs.
• Active investing may be better than buying the Index. Stock prices are slaves to earnings so Investors should look for business models that will be resilient in a challenging environment, and are fairly priced at present. Every market correction makes long term valuations more favourable for Equity investors.
• Long term investing does not need to be about investing in Equities alone. Long term bonds, especially tax free, continue to offer a very attractive risk reward. These must be an integral part of one’s portfolio both for the return as well as Option value (redeem and buy equities in the event of deep market sell off).