Market Hunts for Breakout

Reference: “Are we in a structural bull market?” – June25, 2014

In our previous blog we clearly stated that in our view we are far off from a structural bull market. We anticipated a flattish market for the year and our bet was on defensive sectors outperforming cyclical ones.

In the last 14 months we have seen a flattish market with just 10% rise in Sensex. After the Modi euphoria in May – 2014, majority of investors chased high beta trade and invested heavily in public sector enterprise, construction, oil & gas and real estate. Investors who had taken aggressive bets in these sectors have been hugely disappointed. As we speak there is heightened confusion and general cluelessness on the direction of the market.

Our advice to investors in earlier blog to be aggressive on debt by buying higher maturity funds and being defensive on equities by buying high quality companies has paid off. Our high quality companies’ portfolio has delivered return in excess of 40%. It was a rewarding year for long bond and g-sec investors as well with returns in excess of 12% with a very low level of volatility. The irony is that g-sec funds have outperformed aggressive equity funds having large cyclical bets by more than 5% in last one year.

In our opinion market needs low inflation (not falling inflation), low interest rate (not falling interest rate), high liquidity and low confidence to start a structural bull market. In the current context we have low inflation, comfortable liquidity for capital market and low confidence. We have yet not seen low interest rate but we are extremely confident that we will get there sooner than anticipated. Contrary to last year we have three out of four ingredients to spark a vibrant bull market.

Equities – After making a new high around 29500 on Sensex market has beautifully consolidated around 28000 in the last one year. The market is hunting for cues to breakout above 30000. Majority of participants have apprehension in their minds about index level and valuations. We would like to give our opinion on few major apprehensions:

1.       PE has expanded and no further room for PE to expand – currently we are at historic lows in terms of margins in the case of most domestic facing companies. High interest rates, commodity prices, sharp rupee depreciation and slow reforms had made a big dent on operating margins of the companies. In our opinion we may see big improvement in earnings due to reversal of all the above mentioned factors. In this phase stock prices may move up even after PE contraction and may surprise the street. At the same time we are already seeing few sectors like MNC pharmaceuticals, chemicals, and textiles where PE is expanding with improving fundamentals.

2.     Earning will take time to improve – In June 2015 quarterly results we have seen some improvement in earnings. Contrary to market belief we are of the opinion that small & mid segment will show higher trajectory of growth. Fall in commodity prices & interest rate will have greater impact on that segment of the market. We have already started witnessing earnings growth due to margin improvement. In our opinion companies will use this saving in cost to spur demand. This may lead to faster acceleration in topline growth. CV sales and passenger car sales numbers are already surprising the street.

3.     Interest rate may not go down sharply due to fear of hike in rates by US FED  – In our opinion we are running highest positive real interest rate. We regularly track average of WPI (-4%) and CPI (+4%). As per latest numbers the average was around 0% which makes real interest rate at historic high of 7.55 to 8.0%. This is clearly not sustainable and will fall drastically. In our opinion RBI may be slow in bringing down the rates but markets may price that more aggressively in debt markets. This makes us extremely bullish on long maturity. With respect to US FED rate we believe that in spite of hike we may see rates falling in India and spread between 10 year in US and India may start compressing from current historic high of 5%. We have seen it compressing to as low as 0.50% in the past.

To summarize we believe that the equity market is creating a structural base and is positioning itself for a big move. All the ingredients of a structural bull market are falling in place. Mid and smaller companies have brighter chance of outperforming large cap stocks. Interest rate may fall much faster and much sharper than people on street estimate. We remain extremely positive on long duration funds.

As things stand today majority of investors are still in bank FD’s, accrual funds and liquid funds. We would like investors to show some aggression and divide their money in three parts and invest one part in core blue-chip companies, second part in mid & small caps which can benefit due to faster earning growth and last part in long duration debt funds which will benefit due to fall in interest rate.