Live To Fight Another Day
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Notwithstanding excessive gyrations led by cycles of greed and fear, the financial markets are set to reflect future expectations and often provide a prediction of the times to come. Thus, interpretation of market moves becomes the key skill for market participants and the retail investor, most of whom are financially illiterate, often flummoxed and misled by “advice” from sell-side participants like brokerages, self-proclaimed TV pundits, etc.
It would be premature to interpret the serious correction underway since February 1 as a “normal correction in a bull market” and follow the “buy at every dip” policy advocated in popular media. This correction is fundamentally different due to a confluence of various factors.
First, the market is almost certainly pricing in a higher cost of capital globally, as well as in India. This is precipitated domestically by an expansionary Budget which would be inflationary due to higher MSPs, a higher fiscal deficit than planned due to overly aggressive revenue projections and uncertainty about oil prices. The wisdom of the RBI in not succumbing to the pressure of aggressively reducing interest rates earlier should now be obvious. Internationally, the US recovery and a new Fed chief indicate a faster than anticipated tightening this year. Factoring in a higher cost of capital is a fundamental change in stance for risk capital and will need time to play out on what are highly leveraged equity markets worldwide.
Second, valuations - especially mid-caps - bear no apparent correlation to the anticipated earnings growth and, unless results over the next two quarters improve substantially, it would be safe to say that valuations have peaked. Apart from core industries of cement and steel, it is difficult to surmise where such valuations are justifiable in the immediate future.
Third, the upcoming elections in Karnataka and Rajasthan will induce huge uncertainty in the political scenario, with the BJP’s invincibility not being a given in at least these two states. If the ‘Modi trade’ starts unwinding to some degree, the implications would be significant.
Fourthly, globally the scenario is murky and big shifts are underway. This is reflected in a weak dollar regime prompted by overt government policy, higher commodity prices, sharply rising yields and highly stretched technicals in the US markets. An indicator is that the S&P is 159 per cent above its long-term (1871-2017) exponential regression trend line: In 1999, at the height of the Internet bubble, it traded at 148 per cent, 2008 and 1929 pre-crash levels were at 85 per cent and 74 per cent. There has been no other time in history where such elevated levels did not foretell doomsday! Furthermore, the key ratio of total market cap to GDP stood at 1.55, which is equal to the 1999 levels: the pre-crash levels in 2008 was 1.18. Again, the second highest in history and much higher that the long-term average of 0.75!
Even though the prices of oil have risen appreciably to pave the way for the Aramco offering, billed as the biggest IPO ever, the event itself will be an overhang on the markets. At an estimated $2 trillion valuation, the five per cent stake on offer will be $100 billion, thereby eclipsing the biggest IPO till date of Alibaba at $25 billion.
Volatility exchange traded products – the latest in financially engineered instruments conjured up by my fraternity on Wall Street – are rumoured to be the cause of the mega volatility witnessed on Wall Street lately (1,600 points and 1,200 points on two consecutive days at the time of writing this piece). Historically low volatility over the last few years transformed these instruments into a get-rich-quick asset class of massive proportions – quite like the mortgage-backed securities leading to the last financial crisis in 2008. Even though this will perhaps, not lead to a broad collapse as in 2008, no one really knows the extent of the proliferation of such exotic derivatives, especially structured notes which are not even traded on the exchanges and are sold to small investors. As recently as in Davos two weeks ago, Jes Staley, the CEO of Barclays, who were the first to sell products based on the VIX (US volatility index ), warned against a huge turmoil if volatility returned on Wall Street. The point is the set-up is eerily similar to the first few months of the 2008 crisis much before the actual Lehmann Brothers induced crash happened in October 2008.
The domestic economic scenario too seems very similar to 2002 – impaired ability of banks to extend credit, low corporate profits, high oil prices, lacklustre investment activity – when PM Vajpayee launched the golden quadrilateral project. The difference, though, is both global and domestic markets were at cyclical lows and China was poised to lead a massive global investment cycle. Today, China is in no position to invest and both global and Indian markets are overheated due to sheer liquidity, which is now set to taper off. Besides, the current NDA dispensation has already encashed on sky high expectations over the last few years and its many commendable structural reforms and public capital investment programmes have been already discounted. So another “Ache Din” promotion will be as counter-productive as the “India Shining” campaign.
The market set-up is laced with too much uncertainty and headwinds across multiple vectors. This will lead to heightened volatility which would present huge opportunities to the actively managed, trading- oriented hedge funds. But, in my opinion, purely retail investors would be well advised to wait till the next quarter to gauge the market and must not fall for the narrative of buying into this so-called short-term technical correction, as the market is peaking out for the year.
If I am wrong, there will be, at worst, an opportunity lost. If I am right, they will, at best, remain financially solvent.
I leave the choice to the reader.
