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Global Turmoil & High Valuations

Sep 12, 2016

SummaryA resurfacing of global risks and high domestic valuations are driving the recent market correction. We provide data that support the thesis that the Indian consumer remains strong, and the economic recovery remains in place. We discuss strategies for investors in the current scenario. 

Valuation

Markets broke 24.5 times on the trailing P/E last week. The issue is top most on client’s minds. So we take a look at the market’s valuation and the broader picture to identify prudent investment strategies for the current environment.Ted Williams is the greatest hitter in baseball, a sport similar to cricket in many ways. Ted Williams broke the strike zone – his stumps in cricket terminology – into 77 zones based on how well he hit pitches (balls) in that part of the zone. He then waited for a pitch that was in his highest average zone before swinging.That is the way investors should approach the market. Unfortunately, the market isn’t giving investors a very good pitch (ball) to hit right now. Valuations are at stratospheric levels that history suggests have usually led to sub-par returns forward twelve months. The trailing PE of the Nifty 50 exceeded 24.5 times this past week. The Bank Nifty – burdened with PSUs – and the Midcap 100 are a horror show with P/Es approaching 40.So will this end badly as the prior peaks did in 2000 and 2008?

Nifty 50, Nifty Bank and MidCap P/Es are All Near All Time Highs-

Nifty 50, Nifty Bank and MidCap P/Es are All Near All Time Highs

India Economy

This business cycle is unlike any we’ve seen so far. Liquidity is rampant, crude is benign, inflation is relatively benign, bond yields are declining, the Services PMI and Manufacturing PMIs are showing strong upticks, the consumer looks to be reasonably resilient, while the RBI has an accommodative stance.Alongside these healthy conditions, we’ve got a market that’s been bid up and is trading at peak valuations as investors globally and domestically hunger for yield.This is Not what a typical business cycle peak looks like. Welcome to the dislocated world the central banks have wrought on global investors. We review recent data coming out of the Indian economy below and can’t help but surmise that the domestic economy remains strong, albeit requiring a nuanced approach to investing.

Auto Sales Stellar in August

Auto sales reported a stellar month. Total Domestic sales came in at 23.7%, a marked acceleration over the prior month’s 13.2% yoy growth. Utility vehicle sales were up 47.4% yoy. Overall two wheeler sales were robust as well. Of note however, medium and heavy commercial vehicle sales reported a negative month, down 10.8%.

Ten Year Bond Yields Continue Slow Melt Downwards

Ten Year Bond Yields continued their downward trajectory. Domestic and foreign buyers continue to mop up India’s government debt and the reduction in rates bodes well for the economy, and for corporate earnings.The 10 Year yield ended the week at 7.045. While inflation has ticked up slightly, it’s not been a concern as fixed income investors are always able to see through the short term trends to the big picture, given their larger holding horizon.What we’re seeing on the longer horizon is – what we’ve been mentioning for a few months now, since June – that there appears to be a recognition of quality and stability in India’s debt and this suggests the trend will continue.

PMI Services and PMI Manufacturing Are Strengthening

The Services PMI grew to a 3-1/2-year-high due to strong demand, the PMI rose to 54.7 points in August, up from 51.9 in July. Manufacturing PMI was also at a 13-month high in August, and the composite PMI Output Index climbed from 52.4 in July to a 42-month high of 54.6 in August, highlighting a stronger improvement in private sector economic activity.

Services PMI at a 3 ½ Year High in August

Services PMI at a 3 ½ Year High in August

Strong FII Buying Continues

Indian markets over the past week rallied (up 0.7%), driven by healthy inflows into equity markets. FIIs, in particular, infused nearly INR 2,500 Cr. Since last Friday (02-Sep-16), though, DIIs have been sellers with net outflows of INR -1,500 Cr.

Consumer Credit Card Balance Growth Confirms a Confident Consumer

Further confirming the strength we’re seeing in the consumer, credit card growth outstripped overall credit growth by a wide margin over the past three years. Consumer credit card outstanding growth has clocked a 27% CAGR since March 2014, with the Credit Card outstanding growing to INR 42,500 Crores as of Jun 2016, compared with 24,800 Crores in March 2014, or a close to doubling of the Credit Card industry in just over 2 years!Meanwhile, in further confidence and confirmation of the strength of the domestic economy, private sector banks are investing heavily in opening new branches. Private sector bank growth is back up almost 14%~ yoy and is starting to look like an uptrend.

Private Sector Bank Growth is Healthy

Private Sector Bank Growth is Healthy

Domestic Cargo Traffic Growth Hit a Five Year High Last Month

Domestic Cargo Traffic Growth Hit a Five Year High Last Month

Domestic Cargo Traffic Is Up Over +20% and Passenger Traffic remains Strong

Cargo traffic data confirm what we’re seeing in the purchasing manager’s surveys. Demand is broadening and domestic cargo traffic growth hit a new five-year high last month. We’d also mention that domestic passenger traffic remains strong, generating over 25% yoy growth in the most recent month.

Money Supply Remains Strong

Money Supply Remains Strong

Money Supply Trending Higher

Finally, Money Supply growth remains in a healthy uptrend and unlike previous corrections, there’s no cause for alarm on the monetary supply side as of this writing. 

Global

North Korea Nuclear Test

Geopolitical jitters have added to global investors worries after North Korea conducted its fifth and biggest nuclear test and said it had mastered the ability to mount a warhead on a ballistic missile, ratcheting up a threat that its rivals and the United Nations have been powerless to contain.

Fed Hike Still on the Table

The world’s largest bond fund manager has been pounding the table saying that the bond market bubble has peaked. We’d note that the previous time he was pounding the table, he happened to be doing exactly the opposite in his own book.Broadly though, the market is now pricing in a roughly 40% chance of a Fed hike. This is the normal spook and scare that has typically turned out to be a buying opportunity for Indian equities.

U.S. Elections

Something to keep an eye on. The U.S. Election is looming on November 8th. It’s likely markets will look through and know the answer earlier. If Trump wins, and he stands true to his rhetoric, we could see a global sell-off.

European Banking & ECB Monetization

Investors are well aware of the woes at Deutsche Bank and other European banks. Further, talk of the ECB running out of bonds to purchase is ripe as well. We’re reasonably clear that the folks at the ECB are smart enough to figure out a solution to the bond purchasing program.

U.S. Employment data says the Fed hike on Hold

The Fed Beige Book paints a picture of moderate growth in the US market with expectations to remain at these levels. Coupled with weak US ISM index data (the manufacturing and services PMI both tumbled to 49.4 and 51.4 respectively with the decline in the latter particularly worrying) and the weak jobs data (unemployment rate in Aug-16 at 4.9% vs. Bloomberg consensus of 4.8%), the data would suggest that the Fed will put rate hike rhetoric on hold at its meeting due on 20-21 Sep-16. 

Technical Strategy

The Nifty50 closed at 8867 levels approximately close to opening price of the week. Thus on weekly chart it has formed a gravestone doji, which is sign of caution for the market suggesting either sideways action or a corrective decline. On the daily chart too, price has hit medium term rising resistance trend line from where price has retraced back. Now the immediate support is seen at gap area of 8852 and 8824 levels.If the Nifty breaks below 8824 level, then next support is seen at 8700 odd levels. Also the medium term rising support trend line comes in at 8700 levels, indicating a strong support level for the market. In the Nifty options too, highest open interest for puts is seen in 8600 followed by 8700 strike price. Thus, indicating as 8600-8700 as major support area for the market.On the upside psychological level of 9000 will act as resistance for the market; also in Nifty Call option 9000 strike price has the highest open interest for calls, suggesting market is likely to face hurdle at this level. FII flows cash market continue with Rs 2076cr buying last week, but neither incremental addition was seen in index future long positions nor any major build of positions was seen through options. Thus suggesting market is likely to see sideways to negative action in coming week.Technical Strategy 

Outlook

The strong performance of the auto sector lends credence to the panning out of a consumer-led demand growth story. The Indian consumer is confidently spending and is becoming aspirational and stepping up discretionary spending. Car buyers are upgrading to the compact car segment (Rs.5-8lacs) from minis (Rs.3-4 lacs).Further, the Indian consumer is not a shy borrower anymore. Credit card outstanding has been growing at more than 25% in the last three years and now stands at ~Rs.42000cr – it has doubled since 2012.The 7th Pay Commission and probable imminent GST implementation a fillip to consumption and industry respectively, continue to be the immediate drivers for economic growth.The StrategyOur key observations are thus:
  • The Index is richly overvalued. Worse, it is richly overvalued while not offering the kind of stellar earnings growth and strong balance sheet metrics that a well selected bottom up portfolio would offer.
  • Investors should understand what they own in their portfolio and be comfortable owning it over the medium term. Index benchmarked strategies are likely to underperform.
  • This is increasingly a bifurcated market. Sectors like Telecomm and IT are weak while Autos, Consumer, Financials are strong. It is critical that investors be appropriately invested from a sectoral perspective.
  • In terms of Sanctum‘s equity strategies performance, we would focus on the underlying fundamental track record of our Indian Olympians. We’ll be sharing details on Indian Olympians in coming days.

Dupont ROE of Indian Olympians Shows Superior Metrics Relative to the Nifty 50

Technical StrategyStrategies for High Valuation Markets1. Protecting Portfolios at these Valuations Is a Wise & Prudent Decision While every investor situation is different, we believe a prudent strategy during these times is to be protected from downside, while participating on the upside.There are a couple of ways to hedge portfolios, one requiring an option put purchase, or option call writing and the other being a futures hedge. We execute this strategy via our PMS platform as an overlay to your existing portfolio.For clients interested in deploying this strategy, please contact your wealth advisor.The benefits of a hedge strategy are manifold. The underlying portfolio does not need to be sold or modified and a tax event will not occur on the underlying. Second, it’s far easier to implement a hedge than it is to make a decision on which funds or securities to sell out of a portfolio and where to deploy the proceeds.2. The second alternative is trimming Equity allocations back to Strategic levels and rotating in to Debt instruments or Cash to redeploy into Equities at more attractive valuations. We recommend investors with equity allocations that have run above their targeted asset allocations to gradually and regularly start trimming equity allocations to strategic asset allocation levels. This would free up cash for deployment into Equities at opportune times.Our preferred strategy for this market environment is a hedged strategy that can be managed via our PMS.The Indian economy is healthy and we continue to believe that the economy is strengthening and the consumer is healthy. In light of this, it would be premature to make a call on the market on valuation alone. Rather, we’d want to be opportunistic to add to allocations if this correction is yet another globally sponsored correction.Global dislocations are possible. However, at this point, nothing is visible that cannot be managed by central bankers. Once the dust settles, India is likely to be amongst the attractive regions that investors will direct capital to. So we prefer to let the business cycle or the market dictate a turn in the cycle before we make a definitive call. If the economy is resilient, the correction will play itself out. We do not see an imminent turn in the domestic economic cycle at this juncture.If this is a correction driven by global central banks, it will eventually be an opportunity to deploy into Indian Equities. Investors should take the longer view, trim or hedge portfolios and wait for lower valuations to re-deploy.There are times to be opportunistic and there are times to be protected. We believe we’re in a time where it’s wiser to take a selectively bullish approach while being prudent in managing downside risks.
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