Making the Most of Uncertainty | Value Research Lately markets have gone into a slump. But if you want to make money, you must stay invested amid uncertainty
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Making the Most of Uncertainty

Lately markets have gone into a slump. But if you want to make money, you must stay invested amid uncertainty

These are crazy times for both equity fund and bond fund investors. Instead of moving in opposite directions as the textbooks tell us they should, equity and bond returns have been moving in tandem for much of the last two years.

How did this come about? Equities and bonds are supposed to display an inverse relationship for two reasons. One, when interest rates rise, safe investments such as bonds and fixed deposits earn you a higher return. This prompts investors to demand a higher return from stocks. Therefore, when rates rise, stock prices usually fall because investors tend to mark down stock valuations to the levels they are comfortable with.

Two, high interest rates hurt corporate profits. Therefore, rising interest rates usually act with a lag to reduce equity returns.

When interest rates are falling, the whole process works in the reverse - stock valuations boom and corporate profits receive a kicker.

Rising with rates
But neither equity nor bond returns have been following this script lately. Between September 2013 and March 2015, we had the phase when both equity and debt funds delivered exceptionally high returns. Equities delivered high returns because with India's improving macro indicators - falling crude oil, improving twin deficits, a new business-friendly government at the Centre and material progress on reforms - both domestic and foreign investors turned bullish on Indian stocks and pumped record sums into the stock market.

Though interest rates during this period were rising to the top of their cycle, the bullish sentiment towards equities was based on the view that corporate India would soon see a rebound in its profits, which grew at unusually low rates between FY10 and FY13.

Ahead of the curve
Bond and gilt funds also did splendidly during the same period. Now, bond and gilt funds typically make exceptional returns when interest rates are falling and bond prices rise. But the period from September 2013 to December 2014 actually saw RBI raising its repo rate. Repo rates remained at elevated levels of 8 per cent levels until January 2015. Yet, the bond market rallied sharply over this period.

This was again due to the bond market pre-empting RBI's rate cuts. With the economy still making a slow recovery and inflation moderating, markets kept expecting the RBI to begin its rate cutting cycle through 2014. Therefore, market interest rates, represented by the yield on ten-year G-secs, fell from over 9 per cent to 7.6 per cent. This led to 17-18 per cent returns on long-term gilt funds and 13-15 per cent gains on the NAVs of income funds with long-dated portfolios.

Disappointed!
But funnily enough, after anticipating rate cuts for much of the last two years, when RBI actually began to prune its repo rate from January 2015, both bond and stock markets reacted with nervousness. Between January 1 and June 5, RBI's repo rates were cut by 75 basis points, but the BSE Sensex has lost value. Gilt funds and income funds have also given back some of their gains. Their returns for year to date in 2015 are at a muted 4-5 per cent.

So what's wrong? Equity markets have turned nervous because the big jump in corporate profits that they have been expecting has so far failed to come through. Even in the latest March quarter, corporate India reported single digit sales growth and profit growth, suggestive of a weak demand environment, the lack of pick-up in capital goods orders, falling commodity realisations and continuing leverage problems at some large corporate groups.

Bond prices, on the other hand, have been impacted by adverse global cues. With crude oil prices suddenly rebounding from their lows, inflation fears seem to be back. A recent spike in European and US bond yields has also triggered losses for global bond investors and set off a sympathetic fall in Indian bond prices.

So is it time for the textbooks to be rewritten? Not really. The relationship between interest rates and corporate profits remains the same today as it was fifty years ago. If interest rates fall, corporate profits should rise and that should eventually be good for stocks.

But what has really changed in recent times is the speed with which the market factors in any event much before it actually happens. We all know that stock markets discount future profits of companies and correct if the actual profits fail to meet expectations. This is now true of bond markets too. If the market expects a rate cut and the RBI fails to deliver or hints at a pause, bond investors must expect tough times.

The problem with this trend of markets constantly second-guessing every event is that it creates high volatility for investors. Given the market's tendency to always overreact, if its moves are based on forecasts rather than actual facts, it is bound to go from being too optimistic to being too pessimistic and vice versa.

So, waiting for facts or concrete evidence of a trend, before putting in your money, may now be a futile exercise. So if you wait for corporate profits to actually recover before you invest in equities, you are bound to miss the bus. Similarly if you wait for the RBI to make further rate cuts before buying into gilt funds, you will lose out there too.

To make good returns, you have to be brave enough to invest during the periods of maximum uncertainty. (As Buffett put it, be greedy when others are fearful). Or you have to completely forget timing. Keep making regular investments so that you aren't left standing on the sidelines when the next big move comes along.


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