Feb 5, 2018
“The allure of safety is more perilous than the perceived danger of risk” – anonymous
Fear Makes a Comeback…
Fear returned to the markets last week. This wasn’t a domestic sell-off. The action in the stock markets, the action in the currency, and the overnight action in the U.S. (S&P 500 -2%), suggests that this was an FI driven sell-off. We’ll remind investors that FIs were massive sellers post demonetization and the Trump election in Q4CY16 as well.
Meanwhile, the Markets Have One Close Correlation That’s Held for Years and Still Does… Earnings
In a world awash with data, access to information isn’t the challenge, distilling data into actionable clarity is. One relationship that stands the test of time is that earnings drive stock prices. The chart below demonstrates the very strong correlation between earnings growth and stock prices during the Modi tenure.
On Earnings, Nifty 50 Sales are Up 9.5% YoY, 8.4% Sequentially; Profits are Up 21.1% YoY, 16.7% Sequentially
Our follow-on update is that with 25 companies reporting in the Nifty 50, sales are up 9.5% year over year, and profits are up 21.1%. Recognizing that year over year is a biased metric given demonetization last year, we note that sales for the Nifty 50 are up +8.4% sequentially, and profits +16.7% sequentially. Both are highs versus recent quarters. We’ve shared the company level data at the end of the commentary.
CNX 500 Sales are Up 9.7% YoY, 7.6% Sequentially, Net Profits are Up 23.8% YoY, 23.1% Sequentially
With 166 companies reporting in the CNX 500, this is the first time in three quarters where we’ve seen positive sequential sales growth. The current quarter sales are up +7.6% sequentially, and profits are up +23.1% sequentially. Earnings clearly appear to be matching expectations.
There Is a Very Direct Correlation Between Earnings and Stock Prices…
…That Has Held During the Modi Tenure, and Over Time
Sectorally, Industrials Profits are +17%, Energy +16%, Financials +13%…
…Nearly All Sectors Are Showing Earnings Acceleration & Strong Margins
The Financial Stress Composite Warned in 1998 and 2007 of Rising Financial Stress…
…There Currently Are No Signs of Stress or Deterioration in the Global Financial System
The Budget – Largely Credible
In our opinion, markets focused on the negatives and ignored the positives. The government is targeting increasing spending 10.1% year on year. Yes, the rise in the MSP for agriculture production is a possibly inflationary expense on one side of the ledger, but it will also stimulate consumption and end user demand on the other side of the ledger. Farmers that aren’t starving on one meal a day, and are able to make a profit on production, are incented to produce, earn a profit, and will put money back into the economy. We commend the administration on refraining from handing out large sops, and attempting to incent the farmer to focus on production.
Let’s also recognize the 20% increase in spending on infrastructure, which puts some stress on the budget math, but also creates infrastructure, jobs and multiplier benefits.
While focus remained on the inflationary aspects of the budget, the budget had pro-market initiatives, that will boost rural consumption, build infrastructure, boost corporate profits for MSMEs and spur economic growth.
As regards Modicare, it’s a laudable initiative aimed at uplifting those skirting the poverty line. While laudable, we’d tend to agree with the bond market that the fiscal math on this initiative appears wobbly. However, it’s likely that it will take a fair bit of time for the program to be formalized and the bills approved, and on ground benefits are unlikely to be put in place for months to come.
The impact on the 10 year and potential inflation remains a cause for concern, but we’d note that net market borrowings are lower than FY18.
Net Market Borrowings Are Lower Than FY18
Where Are We Today?
The Positives…
The Economic Recovery Is on Track…Globally and Domestically
The global economy today remains in a synchronized recovery. There may be lurking bubbles in real estate in parts of the world, but there’s no bubble in mortgage finance, no zero down mortgages, and limited leverage in the developed world, except in the central bank balance sheets and developed world bond markets. India has traditionally been at the mercy of FI flows, but we think financialization is a strong force, the domestic market is much deeper now, and the economy remains sound.
Earnings Have Been Impressive Quarter To Date, Sequentially and Year on Year
Earnings momentum is strong. The RBI and global central banks remain ready to leap to the rescue should conditions deteriorate.
Crude Remains Manageable, Under $70, with Rising Rig Counts, Rising Inventories, and Speculative Excess
Crude appears contained and every month additional shale supply gets closer. CFTC speculative longs on crude are at the highest since 2006. Rig counts are up to 946, up 217 rigs from last year. Separately, inventories are rising, so the trends remain positive for crude to remain range bound.
Strong Stimulus Coming to Infra and Assistance for Rural
A 20% increase in infra spending, and a variety of programs intended to double farmer incomes, will translate to rising investment and consumption flows in coming months.
Domestic Short Term Yields Signal No Pressure
Rising short term yields presaged downturns in 2000, 2007, 2011 and 2013. Today’s short term yields are showing no upward bias, suggesting there aren’t any pressures or stresses visible in the economy. Further, the 10/1 spread is positively skewed and rising.
Domestic Short Term Yields Rose in 2000, 2007, 2010 and 2013…
…Short Term Yields Remain Stable Today
The Negatives…
Valuations are at Extreme Levels… Which Begs the Question “Does Valuation Trump All Else?”
The trailing P/E is at 26.04 for the Nifty 50. The relative yield on equities versus bonds now favors bonds, and the absolute P/E is at levels associated with sub-par forward returns.
Long Rates are Rising… and Inflation Remains a Concern for the RBI
The 120 bps rise in interest rates over the past year is a concern, as a rising cost of borrowing impacts growth, spending, profits and valuations. It’s likely that the RBI will take a hawkish tone on rising inflation. However, inflation remains within the RBI’s comfort zone for now. We think markets are yet again running ahead of themselves on pricing in rate hikes. We think the RBI will remain neutral, with hawkish bias, until evidence emerges on price inflation.
The Behavior of Domestic Flows…
A substantial amount of money has recently entered the market that is unsophisticated in nature. Should a correction unfold, whether these investors can stomach the volatility remains a question.
The Withdrawal of Liquidity by Central Banks…
Given the global nature of the sell-off, one can’t help but wonder if the FI flows are related to a withdrawal of liquidity by global players.
The Fear of the Unknown…
Finally, the unspoken fear is fear itself, of valuations and a sell-off. Investors are still holding memories of a sub-prime type crisis lurking out there, and a repeat of 2007.
Outlook
Enhancing Asset Allocation
Since the inception of Sanctum, we have been advocates of a strategic allocation methodology driven by our wealth profile framework. We overlay strategic allocation with tactical shifts, within and across asset classes, as we move through the business cycle. However, the embedded notion in asset allocation theory, that losses associated with drops in equity markets are to be endured, is an area of opportunity to enhance returns. Protective strategies can be a meaningful overlay strategy, to reduce downside volatility, and enhance returns.
We Entered Hedges in PMS Accounts on Jan 25th, with the Nifty at 11,070 Levels
We entered a partial protective hedge on PMS client portfolios on Jan 25th with the Nifty at 11,070. To date, we’ve made hedge calls on Sep 12th, 2016 (Global Turmoil and High Valuations, Sep 12, 2016) in advance of the demonetization sell-off, June 6th, 2016 (Complacency, Event Risk and Bull Markets, June 6, 2016) in advance of the unexpected Brexit sell-off, and prior to the Trump election. Our current put position has doubled in value; however, due to limiting the cost we were willing to allocate to a put to 0.7%, only partial protection has been achieved.
Equities
Structural reforms and investment stimulus are ongoing, and earnings growth is improving. Our fundamental view of a structural bull market remains in place. Should we get 15-18% earnings growth, valuations get back to reasonable. However, given high valuations, we’ve been consistently vocal in recent weeks about reviewing asset allocations, and rebalancing back to strategic weights. We continue to stay the course, preferring principal protected or hedged strategies, or investment managers with valuation discipline. Sectoral positioning and stock selection will be critical moving forward. Earnings reports to date leave us confident that forward three year returns in a well-managed portfolio are likely to deliver strong absolute and relative returns, regardless of index direction or performance.
Fixed Income
With the rapid rise in interest rates, corporate credit looks attractive, particularly higher rated credit, in short to medium term maturities. Our recommendation thus tilts towards higher rated paper in the corporate credit space. For conservative investors with an aversion to short term capital losses, short term bonds remain a safe option.
The Allure of Safety and Perceived Danger of Risk
Finally, we would remind investors that during times of fear and perceived danger, the human mind is ill-equipped to understand risk. It seeks and craves safety, many times to our detriment, in life and in investing. We are hard-wired to fight or flight in the face of fear. The perceived allure of safety – such as moving to low risk investments – can cause meaningful errors and lead to opportunity loss over the longer term. Charlie Munger refers to this as the large long term benefits that accrue by being consistently not stupid.
The human mind is equally ill-equipped to grasp the power of compounding. Over the past 15 years, the “masses” have found plentiful reasons and dangers that caused them to flee the markets. We contrast this with the “few” who’ve stuck it out through cycles. The track records demonstrate that it is these “few” that sport portfolios that have created generational wealth, that are up mani-fold, driven by the power of compounding.
Technical Outlook
The Nifty lost 2.8% for the week to close at 10760 levels. Index touched all time high of 11171.55 at the start of the week and closed near the lows of the week. On the weekly chart index has formed bearish engulfing candlestick pattern i.e. last body engulfing the previous weeks candle which is negative for the market.
Weekly Relative strength index has also given negative crossover with its average indicating negative bias. Now index has retraced 38.2% Fibonacci level of the rise from December 2017 low of 10032 to high of 11171 levels. Holding below 10735 levels, Nifty is likely to see further decline towards 10600 levels and below that 10470 levels. On the upside any bounce back is likely to face resistance at 10980-11100 zone. In Nifty options, strike price 10800 to 11000 Calls witnessed open interest addition suggesting writing activity which is going to act as resistance for the market. Nifty Put/Call Ratio of open interest has seen decline from extreme level of 1.89 last month to 1.09 levels suggesting option writers moving to Calls as market declines. INDIA VIX witnessed spike of 8% to 15.3 levels in Friday’s session which likely to keep market under pressure till it comes down to January lows.
Nifty Daily chart
Nifty 50 (25 Companies Reporting) Sales Are Up 9.5% YoY, PAT Up 21.1% YoY…
Nifty 50 (25 Companies Reporting) Sequential – Sales Are Up 8.4%, PAT Up 16.7%…
