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Not All is Lost

As the Indian economy grapples with macro and micro issues, it opens up ample window of opportunities for long-term investors...

Over the past two-and-a-half-years, every macro-economic indicator of the Indian economy has got progressively worse. GDP growth has halved, the Current Account Defecit has hit new highs and Fiscal Deficit has been at its largest since 1991. The rupee has tanked to new lows, inflation has been persistently high.

The stock market has been supported by FII money. While returns have been positive in the timeframe of the past year, the indices have lost ground since January 1, 2011. As the graph Index returns shows, every index has negative returns, with the mid-caps having done especially badly.

The FII money may soon stop coming in, at least in such quantities. The US Federal Reserve is now reviewing timelines for tapering off the QE programme, which releases about $85 billion of easy liquidity into the global market every month. The Fed says that, as US unemployment drops below 7 per cent, QE will be tapered off gradually. The latest figures released in June show that US unemployment has now dropped to 7.6 per cent. The QE may therefore, ease off within the next few months if the US economy continues recovery.

If QE cutbacks, FII will become more risk-averse. Emerging market economies like India could see a lot of FII selling. Just the fear of QE easing off has already been enough to cause some equity selling. When you add in the looming risks of political uncertainty in India, the market trend could get quite bearish. If the Indian economy is recovering, and equity prices are falling, this may be an ideal situation for a long-term investor. A prolonged period of low stock prices allows for systematic investment. If earnings are climbing and broader GDP indicators are improving during that period, so much the better. But is the Indian economy indeed recovering? There are some early signals that things may be getting better.

First, look at EPS, taking the Nifty as a proxy for the market. Incidentally, the Nifty is also a good proxy for economic activity. It’s a 50-stock index with a good deal of broad, direct exposure to services and manufacturing. Since services plus manufacturing contribute over 80 per cent of GDP, the Nifty offers reasonable reflections of economic conditions. The Nifty’s EPS growth rate (y-o-y) dipped from Q3FY12 onwards. It seems to have started recovering in Q3FY13.

One could also look at the premium of EPS growth over inflation, which may be more revealing. EPS is a nominal number inclusive of inflation. The actual return for an investor is the EPS net of inflation. If one uses the WPI as a measure of inflation, one can chart changes in EPS vs changes in WPI over a long period. This offers an interesting perspective in the long-term.

Take a look at the monthly data in the chart, Monthly EPS vs WPI. This shows the y-o-y changes in the Nifty’s EPS versus the y-o-y changes of WPI from April 2006. The WPI series is based in 2005 so, April 2006 is the earliest period one can compare year-on-year. The EPS premium can be plotted by subtracting the WPI change from EPS change. The 2007-08 boom when GDP was growing at over 9 per cent shows up as an absolutely extraordinary boom period. Inflation was low, at below 5 per cent, and EPS grew at well over 20 per cent. The EPS premium was above 25 per cent in Q3FY08.

The post-subprime period of the global recession was equally extraordinary in the opposite way. Inflation stayed low, and in fact, the WPI went negative for a brief while as demand disappeared. But EPS growth plummeted into the negative zone. At the trough of the recession in Q4FY09, the EPS “premium” dropped to minus 14 per cent. The EPS premium went positive only in Q3FY11. It crashed once more in Q2FY12 and started recovering after four bad quarters.

There is no way to guarantee that this recovery is sustainable but the expansion of the EPS premium is definitely a good signal. We can also look at a similar comparison of EPS growth versus changes in the Consumer Price Index. Take a look at EPS Vs CPI. For what it’s worth, the EPS started growing at a premium to the CPI in Q3FY13. That’s a positive signal too -- the CPI has run significantly higher than the WPI so, the EPS growth rate net of inflation has indeed substantially accelerated in the last two quarters.

Another positive reinforcement for this signal comes from the fact that inflation is apparently dropping even as EPS is rising. The WPI y-o-y change has dropped below 5 per cent, which is under the RBI’s so-called tolerance limit. The CPI has dropped below 10 per cent to a 13-month low in terms of y-o-y change. EPS usually rises only when economic activity is picking up. A period when economic activity picks up, while inflation declines is a sweet spot for investors. This is true even if the GDP growth is low in absolute terms.

Another possible confirmation of GDP growth rates picking up is apparent, in case of a mild recovery in the IIP. The IIP is a volatile series, the data-gathering is often haphazard. There are spikes at the end of every quarter and at year-end due to the reporting methodology. Deseasonalising the data is quite a problem also due to festivals like Diwali and Dussehra, which can “wander” across different months in successive years. That said, IIP does seem to be generating some positive results. The last four months have all seen some positive change in IIP compared to the same period a year ago. Growth has been low but at least it has been positive for four successive months. This comes after a long period when positive months alternated with negative.

In Nifty Vs IIP, if we overlay the IIP against the Nifty’s monthly values, there is a broad correspondence. Equity values fell through late 2011 and early 2012, when the IIP also dropped and started showing negative values. In the period, Jan-April 2013, as the IIP apparently stabilised, equity values also rose. None of this is strong evidence of an economic recovery. At best, it suggests that the worst is over in terms of a slowdown. The EPS rebound in Q4FY13 is not marked but the expansion of EPS premium over inflation is perhaps, the most hopeful signal.

So, here are the assumptions.
* The Indian equity market could fall as the US tapers down QE
* The EPS premium over inflation may stabilise at current levels or perhaps expand
* The IIP will continue to register positive y-o-y changes
* Inflation will continue to trend down or stabilise at current levels
If these circumstances hold, the next 12-18 months could be a great time to invest systematically.