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Markets & Uncertainty

Dec 27, 2016

Be greedy when others are fearful, fearful when others are greedy. – Warren Buffett
Just when things were looking marginally better on the demonetisation front, the honourable Prime Minister riled investors with his speech over the weekend on taxation for capital markets. We are seeing a panicky opening. The timing of the remarks as well is perplexing markets.

However, one must step back at times like these.

We have seen this all play out before. In the past few years, there have been painful bouts of selling, whether it be Mar-15, the Summer of 2013, or the peak of 2010 and selloff in 2011.

Equities are a high return, high remorse asset. If your investment horizon is long, though, as it should be, demonetisation will pass. Markets are higher today than 2011, 2013 and the lows of 2015.

Demonetisation Update

Demand disruption has happened across many segments as a result of demonetisation. The impact on corporate earnings will be felt significantly over the current and next quarter, especially on discretionary consumption and high ticket items. Secondly, businesses with high fixed cost structures will suffer disproportionately with more pronounced earnings impacts. However, the impact is temporary in nature and will not have lasting impression on the country’s potential.

We see the cash situation improving this week, and believe the pain will subside in coming days.

Anecdotally, we see lines getting shorter and we see security guards walking up to ATMs to withdraw cash. Cash is becoming more regularly available.

Demonetisation Will Be a Short Term Bump in the Nifty 50’s Long Term Picture

Maids, drivers, workers have bank accounts and are using ATMs to withdraw cash. We think this is a harbinger of things to come and great news for financial services.

A number of companies have started coming out with news that fundamentals are improving. Maruti Suzuki announced sales are up 8% in December.

From an investor perspective, rural is less than a one fifth contribution to domestic corporate profits. Sales are likely to recover first in the urban areas. We also think consumer demand is backing up and our recovery will be aided by a global recovery and stimulus.

An Increase in the Tax Filing Base

The CBDT reported on Friday that it had identified over 6.7 million cases of non-filers with substantial monetary transactions. If even 10% of these join the rolls of tax payers, that is an additional 6 lakh files. Today, only 0.17% of the population – or ~19 lakh – pay taxes above 1.5 lakhs. An additional 6 lakhs would be a 30% increase in our tax paying base of high tax payers.

Unlike highly ranked emerging markets analysts that have called demonetisation a failure, we think, when viewed as part of a Grand Plan for Reform, demonetisation will yield significant benefits over time.

Global

Regressive Convergence

We live in an age of regressive convergence. Developed economies are fast regressing to the old emerging markets standards while many emerging markets are starting to rise in fiscal responsibility.

Euphoria, Euphoric Valuations and Rose Coloured Glasses

We think theU.S. is officially entering a state of euphoria, with stratospheric valuations. Investors are dismissing the CAPE ratio for the U.S. which just touched levels last seen in the bubble of 2000 and 1929, as a flawed indicator. Is this time truly different?

Protectionism and Borders

Secondly, the U.S. appears directed inwards. Protectionism will be an important part of the U.S. strategy. This adds to our cautious view on IT majors and going forward, our preference will be on domestic pharma growth stories. China seems to be in the cross hairs, and that could possibly be a positive for India. We will have to wait and see how the first 100 days unfold for President-elect Trump.

U.S. PMI Data Remains in Growth Mode

U.S. Services PMI posted 53.4 in Dec-16, down from 54.6 in Nov-16 and vs. expectations of 55.2. Seasonally adjusted U.S. Composite PMI Output Index registered 53.7 in Dec-16, down from 54.9 in Nov-16, to signal the slowest upturn in private sector output for three months.

Equities

A Review of Our Investment Calls in 2016

We normally use the last week to review our calls in detail. This time around, we will only focus on the key calls we made, as demonetisation and global events are front and centre and markets are volatile.

We made a call in Sep-16 to take profits in Equities and hedge portfolios. (see Global Turmoil & High Valuations, 12-Sep-16). We made another good call in Fixed Income. Not all clients took our advice. The ones that did are sitting far happier today.

Loss avoidance is a core philosophy for us. We believe we can do far better than buy and hold. In the event we are wrong, it will not hurt portfolio performance. If we are right, the alpha is significant. We would submit with humility that we have been right on calling peaks and troughs the past six years.

We Launched with a Positive View on Equities in Apr-16

On 6-Apr-16 and 27-Apr-16, we launched our investment commentary at Sanctum with a positive view on the markets, stating we were seeing green shoots in the economy and recommended selective sectoral buy strategies.
“We recommend investors increase exposure to growth assets using a phased, buy on dips strategy. The medium term risk reward on index level investments is not compelling.” – see Market Commentary, 27-Apr-16.

We Warned the Rally Was Weakening Pre-Brexit, But Our View Remained Bullish Buy on Dips

In Jun-16, we did not know Brexit was coming, but technicals told us the rally was weakening and a summer of event risk was upon us.

“Event risks have risen. We are looking at a summer of volatility. We also run proprietary shorter term models… today, they are telling us that the rally is running weak and weakening every week”. – see Complacency Event Risk & Bull Markets, 6-Jun-16.

We Recommended Investors Protect Portfolios/Take Profits, 12-Sep-16, One Day after the Market Peak

On 12-Sep-16, one day after the market peak and the Nifty 50 at 8800, and a strong 1200 point rally on the Nifty 50, we recommended investors take profits in equities and/or hedge portfolios.

“The index is richly valued, while not offering stellar earnings growth or strong balance sheet metrics. Protecting portfolios at these levels is a wise and prudent decision.” – Global Turmoil and High Valuations, 12-Sep-16.

In late July, we called for rates to head lower, and recommended dynamic bond funds

In early Jun-16 and late Jul-16, we went to a bullish view on rates heading lower, when the ‘experts’ were still calling for rising rates. We closed out that call earlier this month.

The way we would look to rectify the situation is to reduce our exposure in the short end of the curve and recommend dynamic bond funds for duration seeking investors. – Gambler’s Fallacy, 01-Aug-16. 2016 is about done. Let us turn our sights to where we are today.

On 12-Sep-16, We Recommended Taking Profits & Protecting Portfolios

Our Call for Lower Rates in June and Late July and a Dynamic Bond Strategy Worked Well

Outlook

Our Investment Outlook for 2017 is headed to the printers. There are lots of cross currents and we address them in detail. We think it is time that investors start being selective buyers, particularly during earnings season. Quality companies are available at valuations that will yield great forward returns on a 2 year horizon. The index remains overvalued.

2017 Will Be Volatile

The French elections are coming up. Trump will be inaugurated and a sell the news, buyers’ remorse outcome looks possible. Protectionism will rise. U.P. elections will be crucial for the BJP’s fortunes. The Budget is announced in Feb-16. Earnings for Q4 CY16 are in Jan-16. There are potholes coming.

Strategy for Volatile Times

It is imperative to stay the course, use volatility and the market’s emotion to advantage, use selloffs to add exposure to Equities. Equities remain at attractive valuations relative to Fixed Income.

We also think the stage is set for the domestic economy to bounce back in the second half.

The Correct Perspective

The market is a manic depressive, emotional, pricing engine. It is demonstrating that these days. The long term investor can take advantage of the manic tendencies of the market.

We discuss these and other implications in our Investment Outlook for 2017, coming soon. For now, Happy Holidays and a fantastic 2017!

Technical Strategy

The Nifty 50 ended below the psychological level of 8000 to close down by 1.89% for the week at 7986 levels. Last couple of weeks have seen market drift slowly downwards which got accentuated in the end, touching low of 7942 during the week, which was short of November’s low of 7916. FIIs have been sellers in cash segment to the tune of Rs 4319 crores (provisional) during the week and created fresh shorts in index futures in last two days. However, the positive thing at the end of the week was that on the daily charts index has formed a doji candlestick – a sign of reversal if market manages to hold above last week’s low.

In Nifty options, 8000 strike Put still continues to have highest open interest suggesting market may see bounce back if it manages to cross above 8000 level. Momentum indicators are also suggesting possible pullback with stochastic indicator seeing positive reversal in oversold zone. Going forward 7900 levels is the critical level for the market, if it breaks below this then next support level is seen at 7643 levels which is the 61.8% retracement level of the whole rally seen from February, 2016 low of 6826 to high of 8969 in September 2016. Holding above 7900 levels, market may see pullback towards 8150 odd levels.

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