Aug 8, 2017
“While enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster” – Benjamin Graham
This week, we address where we are from a macro, fundamental, technical and sentiment perspective and review investment strategy.
The Nifty Trailing P/E is 25.6, a Level that Has Delivered Sub-par Forward Returns
The Nifty 50 trailing P/E is now 25.6, and within a whisker of two standard deviations above the historical mean since 1999. In previous instances that it touched this level, three to be precise, the forward outcome has been painful, with one 25%~ correction and two vicious bear markets unfolding.
Looking over a longer history from the U.S., the S&P hit +1 standard deviation in July 1992, but markets continued to move forcefully higher. The key: earnings rose from 15.76 in July 1992 to 46.16 in July 1999, a roughly 200% growth over 6 years, despite LTCM and the Asian currency crisis. A similar instance unfolded in the 1960s in the U.S. The message is clear. If earnings come through, the market will be unperturbed by current elevated valuations.
The Nifty 50 Trailing P/E is 2 Standard Deviations above its Long Term Average…
…Forward Returns From These Levels of Valuation in the Past 20 Years Have Been Dismal
The Trailing P/E on the S&P 500 is 21, One Standard Deviation above the Long Term Average of 17… …Valuations Are Rich, But Not Excessively So
Having said that, the market has patiently waited for earnings growth for 3 years now. Earnings were at 365 when the current regime assumed office, and are languishing at 395 today, a scant 10% higher.
Market Breadth Is Weakening…
Normally, when a market is making new highs, and the economy is healthy, a substantial proportion of stocks join in the rally.
Unfortunately, market breadth is dismal and diverging. While the Nifty has moved up by a 1000 points over the past three months, the number of stocks in the NSE making new highs is a dismal 100 to 120, or less than 7.5% of the universe.
Further, it is evident in the chart below that participation has weakened considerably since May 2017, from roughly a third of the market to less than 10%.
But Volume Support is Strong, Suggesting a Deep Correction is Unlikely
To confuse matters, volume has been driving the markets higher, with volume hitting an 18 month high in the past couple of weeks. That has been the thesis for the bulls. Flows are coming into the market, and adding to complacency amongst participants that the market is supported.
With roughly Rs. 35,000 crores – or $5.5 billion – in cash at the AMCs, we tend to agree. That explains the action of recent days where each sell-off is being met by large volume purchases, creating a virtuous cycle and encouraging further flows.
The Number of Stocks Making New 50 Day Highs Has Plummeted…
…To About 100 – or 7% of the Universe of Stocks – Making New Highs
Sentiment is Shifting to Risk Taking
We are noticing a rising propensity towards risk taking, an overheated IPO market, and unreasonable return expectations. Investors are also displaying a lack of discipline in prices paid for certain stocks. Finally, the unsophisticated small investor is coming into the market at what appears to be inflated valuations, fitting the pattern we have seen in previous over-extended scenarios.
After conservatism for much of the past few years, investors are embracing risk in the search for high returns, when it may be the wrong time to do so.
Generally, it is wise to add risk when others are fleeing from it, rather than competing with the herd to do so.
What is Clearly Supporting the Market is Volume…
As a Result, a Deep Correction is Unlikely in the Near Term
Cumulative Net Volume Also Suggests No Imminent Concern of a Deep Correction
We also note that the interest in the term “SIP” has hit new highs on Google Trends, and the queries are coming from all over India. Which leads us to wonder if the unsophisticated retail investor is coming too late to the party, or is financialisation an overwhelmingly dominant force.
But the Unsophisticated Small Investor is as Usual Late to the Party…
Will This Time Prove Different?
Searches for SIP
The Macro Picture Remains Benign
The macro environment in India remains benign and attractive. The Agriculture Ministry this week said it received Rs. 16,094.13 crores in the April-June quarter of the current fiscal for implementation of various schemes, which is 53% higher than last year, and the total budget allocation is Rs. 62,125 crores, up 38.9% versus last year.
The RBI stands ready to lower the repo rate. Inflation is falling. Interest rates are falling. Government reforms such as GST and demonetization, housing for all, 7th pay commission, farm loan waivers, investment stimulus and a host of other such reforms are underway. Rate transmission benefits are on their way in the form of rising disposable income.
There is nothing on the macro picture to suggest that we are near a cycle turn. Capacity utilization is comfortable, no visible overheating and none of the normal patterns visible on a cycle turn are close to being realised.
Financials have delivered stellar results and are providing leadership. Beyond that, it is tough to draw conclusive inferences with GST complicating outcomes. Earnings look to be on pace to deliver high single digit to low double digit growth, setting the table for improved numbers in the second half of the year.
The prevailing consensus today is that any severe correction or sell-off is likely to originate out of the U.S. or Europe. The concerns are well known: a global glut of liquidity, complacency about risk, and the potential effects of the liquidity unwind.
The U.S. & Europe Are Showing an Economic Uptick
We would posit though, that the global economic situation is reasonably benign. Both the U.S. and Eurozone are showing upticks in manufacturing activity. The real federal funds rate, which generally rises heading into a recession, currently stands in negative territory. Nor does the yield curve, historically a terrific indicator, suggest an imminent recession in the U.S.
Finally, U.S. Equities continue to offer a yield to investors that is higher than the bond yield. The situation today is such, primarily due to the skewed actions of the Federal Reserve, pumping liquidity to drive rates to abnormally low levels. The earnings yield remains within historical ranges.
Finally, the CRB Metals index is up 20% year over year. As we discussed earlier this year in our 2017 Investment Outlook, metals bottomed in early 2016 and have been recovering since, an indication that the global recovery is underway. The rise in the CRB metals index has bolstered commodity exporters and commodity exporting emerging markets.
Globally, the U.S. and Eurozone Are Showing Strong Upticks in Industrial Production…
…And Manufacturing Activity
U.S. and Eurozone PMIs Are Rising Smartly…
The Real Fed Funds Rate Also Does Not Suggest a U.S. Recession is Imminent…
Nor Does the Yield Curve Suggest Any Recession Risk for the U.S.
Finally, the Equity Risk Premium in the U.S. is Positive Driven Primarily by Woeful Return Expectations on Bonds… Ergo, the U.S. Economy
Finally, the CRB Metals Index is Up 20% Year Over Year…
Suggesting Signs of a Pickup In Global Economic Activity
To summarize, valuations are at extremes, and the market technicals are weak. But strong volume is driving the move. Sentiment is reaching frothy levels. The IPO market is classically overheated. The U.S. and Eurozone economy is recovering nicely, and the India macro story also appears set to improve later this year.
Our key concern remains valuation, narrowing breadth, rising risk taking behaviour, an overheating IPO market and the emergence of the unsophisticated small investor. We are also noting a fervour to deploy funds, a fear of missing out that are driving market action.
Most investors recognize that it is a risky environment, but are unable to identify what the trouble spot will be. As a result, risks that should be priced in, are not getting priced in.
The uncertainties today, are highly unusual. Central bank intervention, indebted and leveraged economies, abnormally low interest rates, $13 trillion in global liquidity, political dysfunction and geopolitical risks are some of the known factors.
Ultimately, Price Paid Determines Return
One incontrovertible fact is clear. Valuations are stretched. Price paid, more than any other factor, determines return. Forward returns from these levels, going back 50 years for the U.S. and 20 years for the Indian markets have generally ended in painful outcomes.
At the index level, earnings have not yet come through. On the other hand, the bottom up picture is rosy, but expensive.
A simple screen for the number of stocks growing earnings at 20% a year over the past 3 years yields 787 stocks, or half the NSE. 294 stocks have continued their growth over the current year as well. It just so happens that the majority are expensively priced.
The mutual fund industry has faithfully played its part, dumping the “buy and hold” mantra in favour of SIPs. Unfortunately, we think it will eventually bear out that human behaviour is the one thing that rarely changes.
The India Story Remains Intact
Today, investors know the narrative, buying into the promise. We have spoken about the positive triggers that are unfolding over the past few months.
Investment Strategy Recommendations
We have been optimistic about equities since the time Sanctum was launched and prior, with a warning in September last year. Today, we think things are yet again poised that the risk reward is skewing towards unattractive for investors.
Yes, flows are buoying markets, the macro picture remains benign and we are not suggesting a turn is imminent.
Instead, we think the following ideas have merit in the current environment:
Review Investment Objective Statements – Over the past year, as equities have delivered outsized gains, we would surmise that clients with exposure to equities review their current asset allocation vis-a-vis their strategic long term asset allocation and ensure alignment.
Rebalance to Strategic Asset Allocation Weights – With equity portfolios up strongly year to date, it is an opportune time to trim allocations back to in-line with long term strategic asset allocation weights. Notably, were markets to slip, or the economy to slow, the RBI has room to cut rates, which could yield attractive returns in the debt market. That is not our call as of now.
Consider Tactical Strategies – If a 15-20% correction would be a concern, tactical protection strategies can be economically structured that would cushion the fall, while not sacrificing the upside.
There are a couple of different ways we suggest clients achieve this. One is the Sanctum Protector, a principal protection strategy that allows full participation on the upside, while providing protection on the downside.
At Sanctum, we also offer clients the capability of structuring protective strategies tailored to custom constraints that provide protection against market downside, while preserving the potential for upside gains. We also manage multi cap and large cap portfolios with hedging.
This eliminates the painful exercise of exiting and re-entering individual funds or securities, an exercise fraught with the risk of damaging long-term return outcomes.
The premise is to re-structure the risk profile of the portfolio rapidly, painlessly and cost effectively to minimize the impacts of market volatility.
Cap Weight Rebalancing – We would further highlight that mid-caps and small caps have delivered strong returns and are likely to have ended up with larger allocations in investor portfolios. We would remind investors that these stocks have a propensity for vicious sell-offs, and a rebalancing of portfolios towards large caps may prove prudent.
We reiterate that flows are strong and that would suggest a deep correction is unlikely. Stock selection and sectoral exposure will have a large impact on forward returns. In addition, an evaluation of portfolio positioning and risk appetite – and recalibration – is a worthy endeavour. The macro environment remains benign. Having said that, an evaluation of portfolio positioning and risk appetite – and recalibration – is a worthy endeavour.
As investment managers, it would be quite easy to take the easy road and stay perma bulls in our investment advice. However, our endeavour is to provide insights with the intent of minimizing regret in an exercise that is fraught with regret, and maximizing attractive investment outcomes.
As always, our advisors are available to assist you and we welcome the opportunity to provide assistance on any issues or concerns you may have.
The Nifty rallied on Friday snapping two days of losses to close at 10066 levels. Index is facing resistance above 10100 levels and is unable to sustain above it. In the below Nifty weekly chart, it can be seen that Index has touched upper end of the rising channel which is acting as resistance for last couple of weeks. Also in terms of price projection of the rally from Mar-16 low of 6827 to Sep-16 high of 8973 when projected from Dec-16 low of 7890 has reached its target of 10036 levels. Thus, index is at critical level and needs to sustain above 10160 levels on tradable basis for the market to rally further towards 10400 levels. Momentum indicators on daily charts have negative crossover with their respective averages, but on higher time frames i.e. weekly chart they continue to remain at overbought levels which is generally the case in long trending up moves. On Friday, in Nifty call options, 10100 and 10200 strike prices saw unwinding of positions, while 10000 and 10100 strike price puts saw open interest addition suggesting option writers may be expecting market to move higher. Recent low of 9944 will act as near term support; below this next pivotal support is seen at 9700. Nifty Put/Call ratio has retreated from 5 year of 1.53 to 1.27, suggesting market has support at lower levels with 10000 strike having highest open interest to act as support. INDIA VIX continues to remain at lower levels at 11.39 which is supporting the market.
Nifty Weekly Chart