The new bailout package from the new US administration has raised some hope of recovery from the recession. In the past month, most global financial markets including India have seen a recovery in stock prices.
Is this a flash in the pan? It may be the start of a new bull market as some optimists are claiming. It may also be a typical bear market rally that subsides as suddenly as it started and leaves bulls trapped at higher price levels.
The macro economic situation is still grim. However, markets are forward-looking and financial prices often lead fundamentals. So it's possible, even likely that the stock market will rally before the economic situation improves.
However certain preconditions are to be met before sustainable bull runs occur. Stock valuations hit attractive lows. There is some promise of earnings improvement, creating positive investor-sentiment. Interest rates are low, creating liquidity that flows into the market. Apart from the factor of reasonable valuations, none of the other conditions are being met now. Gut feel therefore suggests this rally is more likely to fizzle than sustain.
This is in the global context. Indian bulls contend with additional problems. One is pressure on the rupee, which has hit all time lows . This in part is caused by a mass FII exodus. The rising fiscal deficit has triggered downgrades by international rating agencies of India's credit status from “Stable” to “Negative” The rising deficit restricts the government's ability to pump-prime a slowing economy. It also means that government borrowings are crowding out commercial lending. Although inflation has hit a historic low at 0.3 per cent, Treasury Bill and GoI Securities yields are stuck at 4.5 per cent and higher. Commercial rates are twice of that because banks are fearful of defaults. This means insufficient liquidity to fuel a strong bull run. At a guess, commercial lending rates will have to drop by at least 200 basis points before there is enough liquidity to drive buying.
There is another problem and one that is likely to have a serious short-term impact at least. Until there is a new government in charge, there is political instability. What is more, if the Third Front actually makes serious headway in the upcoming elections, it could trigger a panic in the market because the Third Front is seen as neither stable nor economically-savvy.
An UPA or NDA government won't offer high-quality governance but it would have some stability. Also, while neither NDA nor UPA have distinguished themselves as dynamic reformers, they have by and large, followed acceptable economic policy. The fear is the Third Front would be both corrupt and market-unfriendly. It could also make massive faux pas on the foreign policy front.
A crash during the election period would create a serious new buying opportunity for long-term investors. The current Nifty valuations at a level of 3050 are a PE of 14.5, a PBV of 2.5 and a dividend yield of 1.85 per cent. These are acceptable. Investors who have bought at these levels have usually managed to receive a decent long-term CAGR.
But a 10-20 percent drop in stock prices caused by election panic would drive valuations to historically compelling levels. In historical terms, investors who have bought the market at below PE 13, below PBV of 2.25 and above a dividend yield of 2 per cent have always generated extraordinary returns in the time frame of two-three years.
However, the political instability and the macro-economic problems outlined above suggest that the capital gains are unlikely to be immediate. The market could be at current levels or close to the current levels for quite some time to come.
This is definitely a buyers' market. But it is not a market for making fast bucks in the short term. It is a market for investing systematically and steadily over the next year. If prices do crash during the elections, you could increase the quantum of investment.
This article was originally published on May 12, 2009.
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