There is suddenly a wave of reports from broking houses and asset managers, saying statistical history shows that at current valuations our equity markets may be close to a bottom and the time is ripe to start investing for the long term.
Your equity investments would have gone through quite a roller-coaster ride last year and may continue to do so since the bad news just doesn’t stop coming. On Monday, Fitch Ratings revised India’s outlook to negative from stable, while the much-expected monetary easing did not come through in the credit policy review. Then, despite a favourable outcome in the Greek elections on Sunday, the problem is not over and things can turn ugly anytime again. Also, uncertainty in global financial and economic events and our own tryst with domestic policy matters and slowing economy continues.
At this stage, are you still staying away from “risky" equity? Or do you think it’s time to load up a bit on equity with pricing looking favourable? To get you closer to the answer of these question, lets evaluate what the risks are and what’s so far priced in.
Global factors: If the situation in Europe worsens, our markets will be affected adversely. While the voting in Greece over the weekend has eased fears of its exit from the euro zone, in case Greece exits the euro zone (maybe due to its inability to comply with the European Union’s directives), the dollar’s strength against the euro and other emerging currencies will be reaffirmed, driving down the rupee further. That will also be a deterrent for foreign investors in Indian equities as currency-adjusted returns will look bad.
Also, don’t forget the matter of risk aversion and capital flows. Says P.V.K. Mohan, head (equity), Principal Pnb Asset Management Co. Pvt. Ltd, “Global events are important as they will determine capital flows and ours is a capital starved economy." Adds Ambreesh Baliga, chief operating officer (institutional wealth management and research), Way2Wealth Brokers Pvt. Ltd, “Institutional investors are the main drivers and they need to have a handle on currency before committing investments."
Domestic factors: Now to the more pertinent risks of domestic inflation, higher interest rates eating into domestic growth (seen by the sharply slower gross domestic product or GDP growth in the fourth quarter of 2012), the fickle political environment and, as the latest quarter corporate results show, declining sales volume across industries. The Reserve Bank of India also seems to have put up its hands; the status quo on repo rate and cash reserve ratio, despite slowing growth and tight liquidity, indicates it is waiting for reforms on the fiscal front to materialise before extending support. According to Mohan, the root cause of the domestic issues is the fluid political situation which is affecting decision making.
While global risks will determine how liquidity gets allocated to risky assets such as emerging market equities; our own domestic matters will determine how much of that will come to India.
What have the markets priced in?
So now that we know the risks, can we say that the markets know them too and most likely a chunk of this negativity is already in the price? Mohan says the market has indeed priced in a lot of the negatives. “If Greece exits euro then the impact can be disastrous, although it is not expected to happen," says Mohan. The markets that had priced in a sure repo rate cut fell 1.44% on Monday.
Let’s also be clear that though the current market valuation at around 16 times price-earnings (P-E) for Sensex is lower than the 10-year average, economic growth is also at a nine-year low. P-E multiple measures the price you are willing to pay for owning a share at the current level of net profit it earns. So, maybe a lower P-E is not all that unjustified. Says Mohan, “If one were to consider the current slowdown as structural then yes markets should trade lower, but it’s too early to say that."
At the same time, a recent analysis of the fourth quarter of FY12 earnings from EMKAY Global Financial Services says the broader level of stress is reflected in the numbers for BSE 500 companies (excluding Nifty, non-bank, oil companies), where the sales growth decelerated to 12% year-on-year (averaged 21% for the past four quarters). Says Dhananjay Sinha, co-head research, economist and strategist at Emkay, “Fundamentals show that corporate earnings are contracting and growth has surprised us on the downside, which is reflected in slower sales growth. All this is not priced in at current valuations." He feels with less room for expansionary fiscal and monetary action, it is optimistic to look for 15-16% growth in earnings for FY13, which is what the current market valuations are suggesting.
Moreover, keep in mind that domestic equity markets are not so cheap among other emerging market peers, especially compared with China, where the GDP growth is estimated above 8% for FY12.
What we can say is that a lot of the uncertainties are priced in, but there may be some downside left thanks to slower earnings growth. Says Baliga, “We are in a vicious cycle right now and the only way to break it is through positive government policy." The risk of government policy not turning positive is definitely not priced in.
Markets are never linear
While downside risks to markets exist and some events are extraordinary so one knows how these will play out, the fact is market behaviour so far has been very ordinary. In the last 30 years, despite many periods of market volatility and slow growth, the Sensex has delivered a compounded annual growth rate of around 15%, which is quite good (see graph). Current market dynamics and external factors, however, have made market swings much sharper in shorter periods, which scares you of stepping up investments.
What is harder to get a handle of is timing. No expert was able to foretell the sharp rally in January-February 2012; in fact, the sentiment was very bearish in December 2011. Similarly, at the start of FY12, it was very hard to foretell that we would end the year with GDP growth of only 6.5% after clocking in 8.5% in the previous year.
In view of the current risks, equity markets can head lower by at least 10%. At the same time, foreign institutional investors may choose to invest incrementally more in other emerging market equities, but let’s not overlook that a lot of the negatives are priced in. According to a note from HDFC Mutual Fund, Its Tomorrow That Matters, authored by Prashant Jain executive director and chief investment officer, HDFC Asset Management Co. Ltd, when markets are not doing well and news flow is not good, the perceived risk is high, whereas the actual risk is lower as valuations are attractive.
What should you do?
Work on your patience. It is a fair valuation zone for now and only when there are signs of growth picking up will equity markets rise. Says Dhananjay, “It can take another 3-4 quarters before we see earnings pick up."
You can start accumulating good quality stocks over the next 12-18 months as a sustained rally may take time (unless global liquidity goes berserk). Top up your systematic investment plans and if you have lump sum cash, stagger investments or go for a systematic transfer plan.
Investing in equity is one of the few ways to beat inflation over the long run and if you aren’t beating inflation you really aren’t making any returns at all. If you can comfortably invest in a government bond or a corporate non-convertible debenture for 10 or 15 years’ tenor with a coupon rate of 8-10%, why not invest in equity markets or in a share of the same company for 10-15 years and going by the average market return, earn an average of 15% per annum tax free. That’s the kind of long-term commitment equity needs.
Also, don’t redeem from your equity investments when the markets are down because that will make it even harder for you to earn inflation-plus returns and achieve your long-term financial objectives.