The market will go nowhere for the next couple of years in an era of rising bond yields
06-Apr-2018 •Sanjeev Pandiya
Just last month, I dwelt extensively on the overvaluation building up in the main indices. Besides the details given in that article, there were other indicators, which were building up and visible to real-time trackers, like this columnist, but could not be talked about because as they were happening, it was just an opinion, but once it has happened, it turns into a fact.
For one, remember what Adam Smith said a long time back, "Markets will so compose their affairs, as to rob most of the people of most of their money." In spirit, it's a beautiful quote and you would do well to keep it in mind for your future safety. Another good quote is: "The market is a killing machine, a seesaw that's going to go down when the maximum number of people are loaded onto one side of the consensus."
Just a few days back, we were pretty sanguine that 'nothing could go wrong' and this bull run was, what, for the next 50 years (yes, I heard this on TV). At 27 times earnings, we had an earnings yield of around 3 per cent, while bonds are yielding 7.5 per cent. The LTCG impost is toothless, because its very announcement may have set the top of the market for maybe one-two years. Thanks to the grandfathering clause, the government only collects the tax if the market goes over an anyway expensive valuation. I think somebody (in the government) even said that this was done to cool an overheated market.
If that's what it was, my respect for this government just went up quite a few notches. It was Greenspan who first said that it was impossible to locate a bubble until after the fact. Compare it to a Modi government, which has located a bubble, then deflated it in order to protect the long-term internals of the market.
What was surprising was the timing of the other larger bubble in the US. A small uptick in wage inflation, which many have been watching out for, saw a terror-stricken prognosis of an inflationary uptick, a big spike in inflationary expectations and serious Fed action to douse an imaginary fire. A sudden spike in US bond yields has set the earnings yield target at some 6 per cent (India's is still at 3 per cent), almost 50 per cent above the 4 per cent just now. That indicates a 33 per cent decline in US indices, all other things remaining the same. The accelerator was Janet Yellen's last interview, saying the market was expensive (are you sure?), if not in a bubble.
Crowds understand simple messages, so all this data that was pointing to the obvious was ignored, but a single, innocuous event (the LTCG announcement or Yellen's interview) can be a cataclysmic earthquake that will bring down everything. The Indian bubble was built up by furious, but coordinated buying that took out all the resistances, at which trader shorts were built up. These shorts were stampeded by the continuous rise in Nifty levels (driven by an ever-narrower set of stocks, mostly those in the MSCI). This happened even as the mid-cap and small-cap indices tanked seriously, with a very smart ICICI even closing down their small-cap fund. The people who got battered in this were the short sellers. Once they capitulated, the market would have turned on a whim (which was provided by the toothless LTCG provision).
There's a tendency to blame some government action for anything bad that happens, and the Indian media is particularly adept at it. I say that this is just what a sensible government would do, deflate an ever-growing balloon, so that it doesn't burst later.
And now what? I think the market has made its top for perhaps this year. It can either go into a deep correction (up to 20 per cent, around 9,000), a proper bear market (which would be where the last bull market started) or a long 'time correction', where the market ranges from 10,000 to 11,000 for more than a year or two. Thanks to whoever blew up the bull market (right now, I want to credit Mr Jaitley), I'm going to bet on the time correction, not even the deep correction.
How does one play this, and keep whatever is left of the profits from the last bear market? If you got into stocks at the end of the last bear market, you will keep much of the profits (metals and private banks, for example, have a long way to go yet). Keep these stocks and start selling on rallies the broader indices, till they reach sensible valuations. But what would that be?
Conservatively speaking, you could assume zero earnings growth and a 12 per cent nominal growth rate of GDP, that would give you 15 times earnings, the long-term average valuation. The problem of overvaluation comes from analyst forecasts of 20 per cent earnings growth, which the market has discounted three years forward. This is all exuberance and so far has no basis in reality. Manufacturing capacity utilisation is still low, which restricts pricing power. As it crawls up, it will push up inflation, too, so a stock-specific investing strategy might work, but a broad-based index-based view that expects all boats to lift with the tide will come to grief. You could say I am bearish on indices but bullish on specific stocks and sectors. The key is to watch out for those sectors that are seeing steady improvement in capacity utilisation, hence pricing power. These sectors will lead the capex cycle, which will be preceded by sharp increases in earnings.
Overall, I'd say that the market is going nowhere for the next couple of years in an era of rising bond yields. For retail investors, who have resisted the temptation of chasing the top, it's best to stay in bank FDs. For die-hard traders, sell on rallies and hold your nerves. You will survive only if you don't overtrade. Remember to buy insurance some 5 per cent above your selling levels. Dull and boring sectors/stocks might still give value if you buy and forget. But don't try to bottom-fish in this market and certainly, don't buy an early-stage declining market. Keep a keen eye on the global markets. The dollar should be bouncing back against major currencies, particularly the rupee. In fact, that is a good investment theme if you know how to play it (but most people don't). Buy gold as a surrogate for the dollar; gold prices in rupee will track the gains in the dollar.