Living on the edge

The current stock rally reminds us of the euphoria at the end of 2007 when the Sensex had outperformed its global peers.With clouds looming large over the world’s leading economies, retail investors must not forget the lessons learnt from the last crash, says ET Intelligence Group’s Ramkrishna Kashelkar

IT’S NOT EASY BEING AN EQUITY investor in the current macroeconomic environment as the markets try to balance the domestic growth story with global uncertainties. This has translated into volatile markets and insipid performance by frontline stocks across sectors. Corporate results in the past few quarters have been encouraging, monsoon rains are likely to be normal, the Indian economy is growing briskly, FII flows have been good and the Indian stock markets continue to outperform world’s major indices by a comfortable margin. Everything appears perfect for the beginning of another bull-run on Dalal Street. But then, it was no different in the last quarter of 2007 and what followed it is part of folklore now. Will it be different this time?

Not really! The storm clouds have already started gathering over the world economy and the risk of a small jolt snowballing into a full-fledged crash continues to grow. All the leading global economies from the US, Europe and Japan to China are facing their own brands of troubles. As we learnt it the hard way in 2008, it doesn’t take long for economic troubles to seize financial markets. This is why, it is the right time for Indian investors to hedge their bets and protect their portfolios — just as Noah built his Ark when it was still sunny — that can see them through even if a storm were to strike a few months down the line.

In the past three years, the world has witnessed the cycle of over-optimism followed by over-pessimism that reached its trough in March 2009. The global economy as well as the markets have come a long way since then, however, as it often happens, the recovery in the equity markets has been disproportionate to rebound in the real economy.
As investors wake up to the longforgotten fears of a double-dip recession in the US, the Indian markets curiously find themselves in a situation quite similar to that of the last quarter of 2007, when the investment euphoria was at its peak globally. Although it is still early to predict exactly, there are enough indications that
prompt retail investors to be careful going forward.

How the current situation resembles the last quarter of 2007?
Currently, India’s BSE Sensex — the oldest benchmark index — is trading above a price-to-earnings multiple (P/E) of 21 consistently almost for a year. The last time it had traded so strongly and so consistently was in the 12-month period trailing September 2007. And just when a number of market players started getting worried about valuations, an investor frenzy — led by the conspicuous theory of decoupling — drove stock prices even
higher. Four months later, when the meltdown struck, the Sensex was trading above a P/E of 27. In absolute valuation terms, the current market situation is similar to what we witnessed in September 2007 — and it is more than interesting that the decoupling theory is again gaining currency.

In view of the better economic growth prospects, the BSE Sensex has outperformed the US market’s benchmark index, the Dow Jones Industrial Average (DJIA), for the past several years. Accordingly, the Sensex has rightly enjoyed a premium valuation. However, the current level of premium — the difference between the P/E of Sensex and P/E of DJIA — has gone up so much that once again one is reminded of the last quarter of 2007. At present the Sensex is trading with a P/E above 21.5, as compared to 14.1 for the DJIA, or a difference of 7.4 points. In the past 10 years, it was only in the October 2007 to January 2008 period that the Sensex commanded such high premium over the DJIA.
Strong FII flows had been a key characteristic of the period prior to December 2007. In the 18-month period leading to the peak of December 2007, FIIs had poured in almost Rs 100,000 crore in the Indian markets. In the past 18 months, since the bottom of March 2009, the net FII inflows were in excess of Rs 130,000 crore. Increasing FII investments in the Indian debt — both corporate as well as sovereign — have emerged as another important trend this time.
And this time round, the markets have been bloated with huge amounts of speculative money floating around driven by globally low interest rates and accommodating monetary policy by the world’s key central banks. The substantial outperformance of risky small-caps over sturdy large-caps during this period could be taken as an indicator of this speculative investment trend. In the past one-and-a-half years, the Sensex has almost doubled, however, the BSE Small Cap Index has more than tripled. In comparison, a similar period leading to the peak of December 2007 was marked with more sober growth — Sensex doubled while BSE Small Cap Index had gained 125%.
During that period, the rupee had appreciated nearly 15% to a high of 39.4 against the US dollar. Although in the current rally, the rupee has not reached those high levels seen in December 2007, it has appreciated consistently by over 8.5% from the trough of March 2009. It is mainly the economic turmoil in Europe, which is driving investors in search of a safe haven from the US dollar, preventing the rupee to appreciate further.

GLOBAL ECONOMIC TROUBLES
The stock markets tanked globally in May as the Greek sovereign debt problems brought back the memories of the sub-prime crisis of 2008. But the impact proved short-lived with the markets soaring up again in the past few weeks. This appears to be the initial phase of over optimism, which is disregarding the inherent troubles of the world’s leading economies.

Turbulent Times Ahead
After a relatively strong initial recovery, the growth rates of most developed economies are already slowing, despite the immense previous stimulus. In the past three months, more or less universally in the developed world, there has been a disturbing slackening in the rate of economic recovery. As a result, stock markets in the developed countries have grossly underperformed those in the developing ones — notably India’s.
The developed countries such as the US, the UK and other European countries find themselves in a dilemma. At one end, the high level of personal and sovereign indebtedness is risking a debt-servicing problem. At the other end, an attempt to control the debt levels runs the risk of affecting the consumption demand and grounding the already fragile economic recovery.
Amid this, the weak economic activity in these countries is leading to lower government revenues due to their higher dependence on real estate taxes and capital gains, which have been dampened due to falling asset prices. However, their commitments — particularly salary and pension — are hard to cut. As a result, sovereign debt has reached alarming highs. Besides, these economies are facing prospects of under-funded retirement benefits and healthcare costs as the numbers of beneficiaries grow faster than workers due to an ageing population.
In the long run, these high debt levels will have to be curtailed to a more sustainable level, which will indeed be a long and painful process. The famous economist Nouriel Roubini recently mentioned that the advanced economies will “at best have a protracted period of anaemic, below trend growth” as deleveraging by households, financial institutions and governments starts to impact consumption and investments. The process has barely begun.

THE KEY CHANGES HAPPENING
The global economics are undergoing a paradigm shift. The way investors view the world is undergoing a change, which will continue well into the future and nobody knows exactly how things would stand a few months from today.
US treasuries and US dollars — considered as one of the safest places to park investments — could be in for a role reversal, if one looks at the country’s burgeoning debt burden. Noted economist and investor, Mark Faber, recently compared the US government’s current situation to a giant ponzi scheme, meaning the government will have to borrow increasingly more to meet the interest obligations, which would ultimately shake the confidence that investors keep in this asset class. While the reality may not turn out to be as grim as Faber has predicted, the US is indeed facing a problem the magnitude of which is unheard of.
Just last week, the US Federal Reserve’s chairman Ben Bernanke warned the US Congress against withdrawal of fiscal stimulus to bridge the budget deficit, insisting it was too risky for the recession-threatened US economy. The latest set of economic data from the world’s biggest economy showed an increase in weekly unemployment claims, a drop in home sales and easing of economic activity.
At the same time, the equities, government bonds and currencies of the Asian countries are fast becoming “hedges against the global risks”, something unimaginable in the past. By now, Asia has become the world’s great hope for growth and this perception is, unsurprisingly, reflected in the equity market valuations.
One major part of this Asian growth story — the Chinese economy — is also cooling off. Its government’s efforts to curb overheating and contain the asset bubble are likely to result in the country’s economic growth slowing to a range of 8-8.5% in 2010 from 11+% earlier. At the same time, experts believe China is set to enter the phase where incremental demand for labour will exceed incremental supply. Such a scenario will basically end the era of low-cost labour enjoyed by the country. Such a transition would surely have far reaching effects on the country’s economy in the years to come.
Conclusion: The wisdom that emerged after the large stock market shock of 2007-08 is that the decoupling only referred to the economic growth of various regions and that the financial markets the world over didn’t really decouple. This is also applicable to the current scenario. Although India’s economic growth should remain above 8-8.5% in the next couple of years regardless of the global economic slowdown and it remains an attractive destination for foreign investors, the same may not apply to Dalal Street.
High valuations have increased the risk of an abrupt shock if any of the fears related to double-dip recession or European debt crisis become a reality. And the current indications are that the likelihood of these fears turning true — at least partially — is growing with every passing day.
Several market gyrations have made it clear that it is the liquidity and investor confidence that drive the stock market performance — the economic growth plays only a supporting role. Needless to mention, both these factors are extremely finicky and can change tracks fast.
It is, therefore, imperative that domestic investors keep a strict eye on global happenings and not get swayed by momentum when taking any longterm decision. Recommendation: The rangebound market offers retail investors an opportunity to churn portfolios and make them less risky. A global economic slowdown can greatly hurt commodity businesses and high-beta stocks while in the current scenario, where most advanced countries would rather depreciate their currencies, owning export-dependent companies may not be wise. In fact, despite the Shanghai Composite’s underperformance since August 2009, most of the companies focusing on China’s domestic economy have done well.
An investor can avoid taking longterm bets for the time being and book profits on every market spurt. Investors should simultaneously also increase the proportion of less risky, most stable, India-centric companies that have history of generating strong cash flows and generous dividend payouts.