Itís not surprising that investors are showing waning enthusiasm after 18 months of bearishness. Though the stock market is down around 15-16 per cent from its November 2010 highs, the losses are still relatively small. But what has been most damaging is the extended timeframe of the bear market.
Time spent holding equity during a bear market translates into opportunity costs. Assuming an average annual return of 7 per cent for an FDI, the index equity investor has lost 27 per cent or more in past 18 months. Most investors donít calculate opportunity costs explicitly. But they do run out of patience if theyíre seeing an unending trend of losses.
Another problem thatís affecting enthusiasm is the lack of visibility of future earnings growth. Investors find the courage to back equities if they can see a turnaround within say, two quarters. That sort of turnaround time isnít visible yet. Every major industry segment has seen a trend towards lower margins over the past three quarters. Many corporate majors have also seen downgrades in earnings projections over the 2012-13 fiscal.
In a situation like this, the investor can do little but wait until valuations become more attractive, or prices turn 180 degrees. Every stock market has a ďfair-valueĒ. This is the level at which earnings projections, whatever they are, are discounted reasonably, given the prevailing interest rates. Most times, markets trade at some distance from the fair-value Ė price trades either above or below.
When prices are below fair value, the investor can enter with greater confidence about good long-term returns.
Valuations are currently above fair value by any normal estimate, despite the correction through the past 18 months. The Nifty is running at a PE of 18-19. Using an interest rate model, if FD rates are assumed at 7-8 per cent, the fair value would be between PE 12-14. If one was using a PEG model, the projected growth rate required to justify current valuations would be 20 per cent plus EPS growth in the 2012-13 fiscal. Projections are more like 12-15 per cent at the moment.
There are two ways in which valuations could correct downwards. Either, the market will breakdown with a sudden sharp drop that leaves valuations below fair-value fairly soon. Or, prices will continue to drift lower over the long term until valuations gradually catch up, sometime in the distant future.
Opinions can differ as to which situation is less damaging to portfolio returns. My own preference is for a sharp, short bearmarket. A sharp correction presents buying opportunities. The investor must be prepared to average down at lower price levels, rather than sell in panic. If he can employ that strategy, the capital losses become notional and future returns are boosted.
A long drift downwards is much more difficult to handle. The most pragmatic strategy is to continue to invest systematically in default mode, even as the market falls. However, he or she should also keep spare cash allocations in short-term deposits so as to able to hike equity allocation as and when the market moves below fair value. That way, the effect of the averaging down is enhanced.
Implementing either strategy requires good nerves. During a steep fall, the investor has to keep faith that there will be an eventual recovery. During a long drift, he or she has to absorb accumulated losses month after month for an unknown period. There have been markets that have trended down for decades Ė Japan since 1989, for example. India has also seen long periods of downdrift in 2000-2004 and earlier, in 1995-1998.
The Budget did little to change the perception of a long period of macro-economic slowdown. It offers no positive policy changes, and raises the tax burden on an economy thatís already in poor shape. Itís also had the effect of scaring the pants off potential foreign investors. If indicators like the balance of payments, fiscal deficit, inflation, etc.. also get progressively worse, the policy inaction of the 2012-13 Budget may eventually contribute to a crisis.
If that deterioration occurs, or if investors sense that things are heading that way, there will be a breakdown. Alternatively, if FIIs decide to pull out of India or substantially cut their exposure, there would be a breakdown. However, this may not happen. Itís entirely possible that weíre in for another year or more of drift. This is a depressing thought but itís best to be prepared for it.
One good thing is that there is at least a temporary easing of interest rates. This could trigger some sort of rally in medium-term debt funds and it makes life easier for the finance sector and capital-intensive and working-capital intensive businesses.
This means investors could tweak their debt allocations slightly, moving funds from short-term debt into medium-term debt funds. If the RBI continues with rate cuts, this will help generate slightly higher returns.
So, the normal strategy would include the following actions or contingency plans. a) Continue to invest systematically in index funds. b) Accumulate cash resources in short-term and medium-term debt. c) Be prepared to increase equity allocations if the market suddenly drops. d) If the market continues to drift, wait until valuations come close to fair value and gradually increase equity allocations. e) Increase allocations from short-term debt into long-term and medium-term debt funds if the RBI cuts rates further.
A more risky strategy would to be to try and find cyclical stocks that might bottom out over the next six months. The places to look would be companies on a reasonably firm footing Ė that is, with balance sheets big enough to avoid bankruptcy.
One area could be automobiles. Another could be construction. The third of course, is financials. The danger here is that the downside in highly cyclical industries may be considerably larger than the downside in the Nifty itself. If you start picking up cyclicals before they have actually bottomed, be prepared to average down even if thereís a 50 per cent fall or more. If you are going with a cyclical strategy, go overweight on cyclicals by all means. But do this in addition to maintaining a normal equity portfolio via SIPs.
A less risky strategy is a strong focus on export-oriented sectors with significant inflows. Every indicator in the macro-economic space suggests that the rupee will get weaker over the next 6-12 months. Pharma and IT are obvious choices. Less obviously, shipping and hospitality Ė these are cyclicals in fairly bad shape. But they have forex earnings. Again, be overweight in forex-earners by all means. But donít abandon a normal index-oriented stance via SIPs.
There is one set of companies that I would avoid and definitely be underweight in. Thatís anything with a PSU-tag. All PSUs are massively dependent on political will for their well-being.
Indiaís Chief Economic Adviser reportedly said (he later denied it) that he didnít see much chance of big-ticket policy movement before the next general elections. The substance of that thought is probably correct. There wonít be a change in the attitudes towards PSUs unless thereís a 1991-style crisis and maybe, not even then.
My attitude hasnít substantially changed since last month. But then, prices havenít changed much either and there really hasnít been much news-flow that appears to be of great importance. Unless the market has a serious breakdown, youíll just have to tighten your belt and hope that eventually returns will come in.