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Onus squarely on the bulls

Dec 12, 2016

We could have had a global economy showing signs of a strong recovery, a surging domestic economy amidst benign inflation and accommodative policy. Trumpian fiscal stimulus would have negated withdrawal of liquidity and rising rates.

Instead, we face the prospect of a substantial haircut to company earnings at the start of the new year and likely again in Q1 CY2017. One can safely surmise that forward earnings for next year are significantly divorced from reality at this stage.

Valuations are a cause for concern

A conservative 10% cut – we think the number will be larger – would bring Nifty 50 earnings down to roughly 338, and the trailing P/E would move up to 24.4. That is the best case scenario. A more realistic 15% cut to earnings takes the trailing P/E to 25.9. Forward earnings estimates are meaningless today and have to be slashed as well. The ‘recovery’ back to status quo is now expected in the June quarter at the earliest. The market could reprice equities, or take the news in stride. Sentiment, global action and the budget appear to be the keys in determining how things pan out.

RBI chose global factors over domestic

We had been expecting a 25 bps rate cut by the RBI. Some were expecting a 50 bps cut. The RBI did not clearly articulate its decision to hold off, but the only reasonable rationale is that it chose to act on global cues rather than domestic, such as the rate action in the U.S. and the recent actions of foreign debt institutional investors.

Hopes for the bulls now rest on the Budget

Can we hang our hat on a budget that will bring back the animal spirits? Possibly, but our confidence is wobbly at this point. With the absence of any clear windfall via the demonetisation exercise, as well as the near consensus criticism of the move, it may well be that the government will now back away from bold and sweeping reforms in the Budget.

Broad Money Supply Has Dipped Dramatically due to Demonetisation

 Demonetisation effect on Broad Money Supply

The worst case scenario is unfolding with demonetisation

Demonetisation has been discussed ad nauseam and it is likely most of the forecasts are going to be wrong. However, a safe assumption would be that the expected low hanging fruit has not come forth and it is going to be a battle with further measures required to address corruption and move to a cashless society.

Uncertainty over the Government’s plans does not augur well for investment

We are now resigned to a scenario of major uncertainty in sectors such as real estate and gold. Global investment is also likely to slow down or back off until clarity emerges over the extent of demand destruction and resilience of the domestic economy.

Government’s plans


Global recovery is a positive, but valuations remain a concern in the U.S. as well

A slew of positive data has been coming through globally. The U.S. Nov ISM composite index rose to a 13 month high at 56.7 from 54.5 in Oct. U.S. Nov ISM Services index rose to a 1 year high at 57.2 from 54.8 in Oct. Interestingly, the U.K. Nov Services PMI rose to a 10 month high at 55.2 from 54.5 in October. And Eurozone Nov Composite PMI rose to an 11 month high at 53.9 from 53.3 the prior month while services PMI rose to 53.8 from 52.8. Not to be left behind, even Japanese retail sales rose by 2.5% MoM in October (the highest since May-14).

Global recovery

Tax stimulus benefits will take at least 3 quarters to show through

Globally, a massive tax stimulus looms on the horizon, but any benefit of the stimulus will not be felt before the fourth quarter at the earliest. It will take time to write the bills, push through the bills and move to ground implementation.

U.S. valuations are approaching stratospheric levels

Unfortunately, the backdrop in the U.S. is also held back by stratospheric valuations. Economist Robert Shiller’s CAPE ratio has hit historical overvaluation levels last seen at market bubble peaks. Others believe that the U.S. is close to approaching bubble valuation in its equity – and real estate – markets.

Massive cross-currents at play

We live in a time of massive confusion and cross currents. Will Trump’s massive stimulus trump rising treasury yields? Will protectionism rise? What about the reversal underway in global liquidity not just in the U.S., but also in the EU, and China.

While the global recovery and massive stimulus will act as tailwinds for Indian companies, the matter of valuation remains unresolved in the U.S. as well. We expect Trump will take a softer line on trade than some of his rhetoric during campaigning. That being said, Trump’s comments this weekend were aimed directly at Indian IT companies. Not a good sign.

ECB heading towards a potential taper and Italy a question mark

While the ECB left central bank rates unchanged, 2 key aspects of its QE program surfaced:

  • The program would be continued till Dec-17 or beyond “ïf necessary”
  • The asset repurchases would drop to €60bn/month from Apr-17, from €80bn/month currently.

Markets correctly perceived this as a tapering move by the ECB.

Crude Oil

OPEC at its 30-Nov-16 meet agreed to cut its output to ~32.5m b/d commencing from Jan-17 for a period of 6 months (with an option for another 6 months’ extension). Non-OPEC members may also cut output by 0.6m b/d, including 0.3m b/d cut by Russia. With Crude clearly showing strength, it remains to be seen how alternative sources of oil supply which were unviable due to the suppressed pricing environment, may now become potentially viable.


The Nifty managed to notch up more than 2% gains for the week on the back of a strong rally in global equity markets to close at 8262 levels. RBI’s surprise status quo stance shocked the market, but it was immediately shrugged off as global markets which are seeing fresh breakouts on the upside had a positive effect on our market. The Nifty has seen a bounce from oversold levels and is in pullback mode. Momentum oscillators still have further room on the upside, suggesting the market can continue to rally before it loses steam. The immediate resistance zone for the market is seen at 8320-8340 levels, above that, the next level is seen at 8440-8450.

On the downside, support is seen at 8080-8055 levels and major support for the market is at 7900 levels. Fresh FII buying was seen in the index future last week, but is still well off the heavy build-up that was witnessed in the September series. Also the Nifty future open interest is also almost half of the September peak, suggesting market participants are still cautious. Nifty Put/Call ratio open interest which, stands at 1.10, will soon be approaching its higher end. India VIX, measure of volatility has sharply come off its highs and will soon reach its lower end. Thus, the low build-up of long positions and supplementary derivative data suggest that the market is likely to have a limited upside. Going forward, a pullback can be expected to continue towards 8340 and then 8450 levels; where it needs to be seen if the market is able to sustain at higher levels.


Maybe this bounce is a gift from the markets. Safe to say, the onus is squarely on the bulls to demonstrate normalisation and recovery. We would list a return of consumer confidence, a freeing up of purse strings, restored faith in the Modi government and a complete recovery of earnings to pre-demonetisation levels as key areas to watch out for.

Strategic long term buy and hold versus tactical strategy

For long term investors, this is not a turn in the business cycle, at least it does not appear to be the case as of this writing. It is risky to try and time the markets and be right twice. Stay invested, forget about your portfolios and in a few months, demonetisation will be an unpleasant memory.

Secondly, we have tactical investors that are interested in loss avoidance. Most humans experience an inordinate amount of pain relative to pleasure. Holding on to equities as valuations skyrocket will be a challenging task. The wisest approach, in our opinion, would be to leave the underlying portfolios intact and look to purchase out of the money protection. For investors in our PMS services, we aim to do precisely that using minimal allocations (less than 1%) to protect portfolios during times of risk.

Market timing indicators suggest a short to medium term top approaching

Our proprietary indicators are edging towards a short to medium term top in the markets. Secondly, the pattern we have seen over the past few years suggests that there is a substantial likelihood of a re-test of the bottom set recently.

Sentiment appears to be all in on U.S. equities and volatility there would be a negative for Indian equities.

Marry high valuations, market timing models suggesting a top, and dismal fundamentals suggesting a dramatically worsening economic environment in the short term and the onus is most certainly on the bulls.