Aug 16, 2016
Summary With the Nifty 50 trading at stretched valuations, it’s instructive to look back and analyse the effectiveness of a high P/E based strategy.Equities
The Nifty 50 is at a trailing P/E multiple of 23.7 times earnings. The chart at the bottom of this page highlights prior periods that the index traded at similar or higher valuations. If you’d been an investor and exited the market in 1999, 2007 or 2011 on the basis of today’s high P/E multiple, you’d have witnessed the index move higher by 21.3%, 21.3% and 19.6% respectively.Exiting at Current P/E Valuations Would Have Seen the Index Rise a Further 20% in 3 of 4 Cases…
Nifty 50 signals at P/Es greater than 23.5
A P/E based strategy
As the table above demonstrates, there were four instances in the past 17 years where valuations reached current levels or higher. You’d have made the right decision in exiting only once out of the four cases, or a 25% win rate. That’s a pretty dismal win rate. Let’s take a closer look.Key Problems with a P/E Based Strategy
We see a couple of significant problems with a high P/E strategy. First, an investor exiting the market based on valuation would have suffered regret as they watched the index rise an additional 20% in three out of four instances. Second, there would be the matter of re-entry. The investor would have given up 20% upside in three of four instances, and would have had to time the re-entry into markets. That’s a tall task, one few professionals or investors are able to achieve this successfully. In summary, a valuation based strategy wasn’t optimal in timing market exits. On the other hand, we’re certainly not advocating buy and hold. Rather, what we’re putting forward is that each cycle is unique and one number (the P/E) does not capture the intricacies of successful tactical allocation. Each cycle is different and unique.A Preferred Approach to Asset Allocation
Our preferred approach would take into account the key economic variables of the business cycle such as domestic central bank policy, inflation, crude oil, investment and earnings. As we make the case later, this approach takes a different view to where we are in the business cycle.A Review of India’s Financial Sector Progress
India’s Credit Market Size
One of the reasons we’re bullish on Financial Services is because of the relative infancy of the credit industry in India. India’s credit to GDP ratio is a paltry 52%. China and the U.S. are both above 150%. This means that the credit industry, in toto, could triple and we’d still only be at par with other large economies. Bright prospects indeed.The Jan Dhan Yojana Gains Momentum
The objective of the “Pradhan Mantri Jan-Dhan Yojana (PMJDY)” is ensuring access to various financial services like availability of basic savings bank account, access to need based credit, remittances facility, insurance and pension to the excluded sections i.e. weaker sections & low income groups. The total balance in bank accounts has increased from 10,500 crores on 31st January 2015 to 40,750 crores today, a 2.9 times increase. Impressively, there has been a 3.4 times jump in the rural bank share of this total. The number of bank accounts have increased from 12.5 crores to 22.6 crores on 31st January 2015 to 40.7 crores today, up 81% with an 83% jump coming through the rural regional banks.India’s Credit % of GDP (52%) Has A Long Way… China’s at (155%) & U.S. (190%)
Over Six Million Folios Have Been Created During the Modi Tenure
The number of accounts with zero balance have reduced drastically from 8.4 crores on 31st January 2015 to 5.4 crores today, down 35.2%. There was a 48.5% drop in accounts with zero balance coming from the Rural regional banks.
The number of bank accounts opened under Jan Dhan stands at ~23 crores.
We’re at the very nascent stages of the financialization of the country. The scope and size of the financial opportunity remains the fundamental underpinning of substantial overweight in Financial Services.
Domestic & Global Economy
The global outlook is still murky. The U.S. reported strong payroll numbers alongside declining inventory investment. The Euro area banking sector remains stressed and Brexit has added to uncertainty. Downside risks have intensified in Japan amidst contracting industrial production and a lacklustre stimulus package, whereas growth has stabilized in China on the back of strong stimulus. Domestically, the monsoon has picked up pace and is 3% above the cumulative rainfall average to this date. Sowing of all crops is strong and above last year’s average. This bodes well for agriculture’s contribution to GDP as well as a pickup in rural spending. Industrial production is up 3.0% in the current fiscal year, excluding lumpy capital goods such as insulated rubber cables. Further, capital goods production is up 8% excluding lumpy items. The PMI and the Industrial Outlook Survey both reported a pick-up in new orders, domestic and international. More good news on the Services front. The Services PMI continued its thirteenth month of successive growth on the basis of a sharp acceleration in new business. The improvement in the services sector is getting broad based and continued strength is evident in automobile sales, railway, port and freight traffic, tourist arrivals, and domestic air passenger traffic.Fixed Income
Inflation Ticks Up, RBI On Hold
We’ve been a bit perplexed by expectations from economists calling for a rate cut this year. We can safely put those expectations of a rate cut to bed given the tick up in inflation above the RBI’s comfort zone. F.M. Jaitey also indicated that he would need more money in the fiscal year to pay for the pay raises for 10 million state workers and pensioners. The pay raises again indicate upward pressure on inflation.Foreign Flows Continue to Be Strong
Increasingly, we are seeing data items confirming our view that emerging markets are now perceived to be alternative safe havens. Global investors are aggressively buying higher yielding emerging market Asian debt, buoyed by the belief that Brexit ensures continued easy liquidity conditions. Malaysia enjoyed inflows of $1.4 billion in July, on the back of strong fundamentals. Indonesia saw $625 million in inflows in the first ten days of August. India saw more than $1 billion in bond inflows last month and offers one of the largest yields in the region. South Korea saw $1.4 billion being bought in the first ten days of August. Thailand saw inflows of $620 million in the first five days of August. It’s obvious that there is a shift of capital to Asian markets underway. These numbers are a drop in the bucket for foreign institutions and is arguably hot money. With domestic inflation ticking up, the continued decline in the domestic 10-year bond purely appears to be a flow driven dynamic.Rupee Stability Continues
The Rupee has demonstrated impressive stability in the 66-68 band over the past few months. This stability will like add further impetus to the perception that the Indian economy is stable, relatively strong and an attractive investment destination. Given the widespread increases in allocations to emerging markets debt, we think flows into domestic bonds are likely to continue. The trend for the 10 year is now clearly headed lower, despite the uptick in inflation. As long as strong flows and demand exist for Indian bonds, we expect the 10 year to continue its decline in a gradual manner lower. The appropriate strategy to benefit from the current environment is a shift away from short term debt towards accrual, credit and tactical exposure to duration. Tactical shifts in duration products remain difficult to execute given the three-year horizon necessary for tax efficiency and strategies must take into account an investor’s tax situation.Technical
Another flat closing for the Nifty50 index at 8672 level for the week. Market has been largely sideways with positive bias, for the last four weeks now. FIIs inflow continues with Rs3835cr (provisional) buying last week. In index future too, FIIs are still holding on to long positions, while call writing and put buying that that has been seen is likely to hedge long positions. On weekly chart, momentum indicators have reached overbought levels, but they can continue to remain overbought in uptrend and change of direction will come once reversal in price is seen. Index is facing resistance at 8700 levels, but on the lower side index is forming higher lows which is a positive. Nifty options PCR currently at 1.03 has again moved above one level and INDIA VIX is at 8 month low of 13.77 supporting the market to move higher. Hence breaking above 8700 level, index can see 8900 levels on the upside. Though for the second week index has formed hanging man candlestick pattern, technically which is sign of caution. But the confirmation for the same, would only come once index breaks below 8500 level decisively. Also in Nifty Put options, 8500 has highest open interest indicating important support for the market. Bias for market is positive till 8500 level holds on downside and move above 8700 levels, index can rally towards 8900 levels.Outlook
The current cycle is significantly differentiated from each of the prior four cycles where valuations were extended. Corporations are starting to reap the benefits of declining interest costs, which will translate to rising margins and operating leverage. While there is certainly some cause for concern on the inflation front, we believe the monsoon and the sowing season were a welcome relief and prices for pulses and vegetables should come down in coming months. The domestic recovery is broadening with services remaining strong and rural to contribute to economic growth in coming quarters. Companies continue to deliver respectable earnings growth and we’ll have an update on earnings at month end.Sentiment Remains Strong
The fervour to own Indian equities and bonds is strong, globally and domestically. Our preferred strategy remains a buy on dips strategy. Stock selection will be a key determinant of portfolio returns in a period such as the one we’re in. We don’t see signs of excess except on valuation. Traditional end of cycle characteristics aren’t evident and we’re in the middle stages of the recovery cycle. For now, we don’t see a compelling reason to alter our exposure or positioning.