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Complacency, Event Risk & Bull Markets

Jun 6, 2016

Executive Summary

It is not the strongest of the species that survives, nor the most intelligent. It is the one that is most responsive to change. – Charles Darwin’s Theory of Evolution

A Summer of Global Event Risk

  • A horrible jobs report in the U.S. puts the Fed on hold in June… we hope.
  • Sharpest pace of decline in Japanese operating conditions in 40 months.
  • Brexit is too close to call, adding to event risk.

India’s Bull Market Intact

  • This week, we compare India’s bull market prognosis with the longest U.S. bull market
  • We look at the track record of valuation driven investment strategies at current levels
  • The long term structural story of India is intact, but the macro picture has weakened marginally.
  • Leading economic indicators remain strong.
  • Our short term technical indicators are signaling the rally is weakening each successive week.
  • But the dismal macro data is masking stellar returns in domestic growth stocks – large, mid and small.
  • Tactical exposure modification and asset allocation are optimal ways to navigate event risks.
  • Our PMS strategy does exactly this.
  • No change to our Bonds outlook.
  • On Equities, we advise patience in deploying additional capital and waiting for better prices. Additional details in the Outlook section.


Darwin’s quote applies equally well to stock picking. It’s the management that is watchful and responsive to change that makes for a great long term investment.

A Page from the Longest Bull Market in History

In 1982, the 10 year bond in the U.S. sat at 16% and very few would have guessed the U.S. was about to embark on the longest bull market in history.

Sixteen years later, in 1998, the 10 year in India sat at 12%. The NDA presided over a decline in bond yields down to under 6% and in doing so, ushered in a bull market and a rip roaring decade of growth.

In May 2014, the 10 year in India was at roughly 8.8%. In 2 years, the BJP has succeeded in lowering the 10 year yield to 7.45%.

We think rates are headed to 4-5% longer term. If so, India will be headed for its own 20 year bull market.

A Declining Rate Environment Is a Nurturing Ground for Bull Markets

From 1962 to 1982, U.S. Ten Year Bond Yield Rose from 4% to 16%… …and the S&P Delivered 3.3% CAGR


The Next 20 Years, Bonds Declined From 16% to 4%… …Despite a Severe Crash in 2002, the S&P Delivered a Respectable 11.8% CAGR


Finally, Bonds Declined in 2002, 2008 and 2011… …Setting the Stage for Bull Markets in Each Instance


Why Rates Should Head Lower Longer Term

We would ask why not when rates are low in most emerging and developed markets? Gov. Rajan spent many years studying the U.S. and knows this is the path to prosperity.

Here’s news we’ve seen in just the last 2 days:

The government plans to set up 250 small agro-processing clusters with 32 lakh tonnes of food processing capacity. India has started moving towards zero tolerance of food wastages. The Modi government has sanctioned 37 Mega Food Parks, out of which eight have been operationalised, six in 2 years of NDA tenure. 134 cold chain projects were sanctioned and 81 have been completed, 44 in only 2 years of NDA tenure.

GST will help reduce inflation further by reducing transport costs and wastage.

India is emerging as one of the top global hubs for innovation. Reform in the agriculture sector will come from governmental and entrepreneurial initiatives that address the massive productivity and wastage opportunity. Why wouldn’t inflation and rates come down?

We’re Sticking to a Bullish View Despite Event Risk

  • We’ve seen Reagan, Bush, Clinton, Bush, Obama. In our opinion, this government is by far more hard-working, innovative and productive and this leader is as good as they get.
  • Leading indicators are signalling growth.
  • Earnings are coming in above expectations.
  • Inflation is in secular decline, with hiccups along the way.
  • The government’s vision is starting to kick in.
  • India is the fastest growing large economy.
  • FDIis coming in droves…Japan, Sweden, China (Gionee), U.S… this is capital formation too, so we’re not obsessed about domestic private capital.
  • Road Construction is up +16%, national highway construction is now at 20 km a day.
  • Commercial vehicles sales are up +27% and light commercial vehicle sales up 13% yoy respectively.
  • Cement sales are up 17% yoy.
  • The urban consumer is healthy, the rural consumer should start recovering.
  • Cumulative FI flows to Equities have now turned positive over the prior 6 months. (see chart page 4)
  • We suspect many investors are underexposed to Equities, providing a floor to Equities.
  • SIPs are funnelling thousands of crores to Equities every month.
  • Sentiment has changed. Today’s investor is bought into Equities as a great place to be for the long term.

Does Valuation Trump Potential?

Many believe high valuation leads to dismal returns. Some AMCs base their investment philosophy on this simple premise.

So let’s take a different look at valuation.

Could investing be as easy as exiting when valuations get high? The Nifty 50 today sells at roughly 22.5 times trailing earnings. Similar valuations would have had investors exiting in 2006 and also in 2009, and forgoing 80% and 50% further upside respectively (see chart below).

So using a simple metric doesn’t work fabulously. We fall back on the art vs. science debate. Investing is art as much as science. There are no rules that work all the time.

Earnings Update

As of this writing, both the Nifty 50 and the larger universe have delivered mid-teens earnings growth and mid to high single digit sales growth. That’s impressive, considering all that’s happening globally is a headwind.

Valuations Reached Similar Levels in July 2006 (Nifty 3500~) and Oct 2009 (Nifty 4700~)… …Investors that Considered Valuations Alone & Exited… … Missed a Further 80%~ Rise in 2006 and 50% in 2009


Rising Yield Spreads Are Signalling that Economic Conditions are Improving

 Economic Conditions

…and Foreign Equity Market Flows Are Again Turning Positive, Great News


Nifty 50 Earnings Scorecard – 15% Earnings Growth ex PSU & Steel


CNX 500 Earnings Scorecard – 15% Earnings Growth ex PSU & Steel


Fixed Income

India may be the fastest growing economy and offering high yields, but overseas fixed income investors remain sellers. We think this has much to do with carry trade mechanics and negative yields in carry trade originating markets and less to do with Indian fundamentals.

Bonds were range bound during the week as the market waits for the Fed and actual progress of monsoon. The benchmark 7.59% bond traded at 7.49%.

Rupee and bonds were negatively impacted in this week on media reports that the RBI Governor Raghuram Rajan may decline an extension of his term. We expect RBI to maintain status quo on rates at Jun. 7 meeting.


Plummeting Odds of a June Fed Hike

The worst jobs data since September 2010 essentially ensures a Fed hike in June is no longer in the cards. The Labor Department report said the U.S. economy added just 38,000 jobs, far below economist estimates of 162,000. Labor participation rates worsened and part time jobs rose dramatically.

The Central Bank narrative that things are “awesome” is now laid bare as hope and fantasy.

June rate hike odds crashed to 4% and July rate-hike odds have plunged to 31% from 48%, as tracked by CME.

Fed Rate Hike Odds Have Plummeted

 Fed Rate Hike Odds Have Plummeted

The Merry Go Round continues

The Fed threatens to hike, markets tank or the data come in below expectations. The Fed delays the hike. Markets recover. Rinse. Repeat.

Gov. Rajan is absolutely right. There should be some accountability on the massive liquidity and intervention that has been unleashed on the global economy.

Dismal News Out of Japan – a 40 Month Low on PMI

Abenomics was unleashed in concert with QE in April 2013. Things aren’t going to plan as April’s Manufacturing PMI came in at 47.7, a 40 month low, with output and new orders declining at the quickest rates in 25 and 41 months respectively.

This was the worst PMI print since since Jan 2013.

 Japan's PMI is at a 40 Month Low

Brexit – Too Close to Call

In a speech in the U.S., Chris Grayling, leader of the House of Commons asked Americans: “Would you accept an American Union of North and South America, its parliament sitting in Panama, with power to impose laws on the United States, and a high court whose decisions overruled those of the U.S. Supreme Court?”

“Would you accept an American Union that granted all the peoples of Central and South America and Mexico the right to move to, work in, and live in any U.S. state or city, and receive all the taxpayer-provided benefits that U.S. citizens receive?

That’s the case for British withdrawal from the European Union — in terms we all can understand.

Gold, Crude & Commodities

No change on our view on Gold or Crude. While the jobs report was terrible, it isn’t indicative of risks that would lead us to consider the precious metal. Crude remains in an uptrend.


Markets make mistakes. The greatest mistakes are driven by emotion – either too much greed or too much fear, too much optimism, too much pessimism and not analytical.

Have we reached that point of excessive optimism today? We’re hard pressed to think so. There’s a lot of fear out there globally and markets have been successfully climbing these walls of worry for weeks.

Longer Term Bull Intact, Shorter Term Event Risk & Volatility

There is event risk.

As active managers, we address event risks by modifying our risk profile and tactical allocation. We think it’s the optimal way to manage portfolios today.

We also run proprietary shorter term models that provide useful inferences for investment management. Today, they’re telling us that the rally is running weak and weakening every week. This is a probabilistic call as short term market forecasts is not a business we are in. We mention this purely as an observation to our readers.

The probabilities suggest we’ll see better entry opportunities in coming days or weeks.

This ties in with our fundamental view that macro conditions have worsened marginally and valuations have gotten more expensive.

We were amongst the first to mention green shoots in April. Today the Nifty is up over 700 points since that time, climbing the wall of scepticism and worry. Our cautious stance is from a shorter term timing perspective. Our long term bullish view remains unchanged.

Patience in the Short Term and Buy on Dips

For longer term investors, we believe the structural long term story is intact. We would look to raise cash for deployment if lower prices present themselves.

Valuations have gotten ahead of themselves in many securities; however, these stocks are delivering impressive earnings growth, growth that isn’t easy to find.

It’s never easy to say sell just on valuation. You’d have sold Microsoft, Google, Infosys, Amazon and a host of other names if you’d followed this advice.p>

Event risks have risen. We’re looking at a summer of volatility.

How you choose to manage risk is a decision you and your wealth manager should be very clear about.

Many institutional managers are unaware of the earnings Indian companies are delivering because it’s masked by PSUs and a handful of highly indebted companies. In contrast, the U.S. rally has been driven by buybacks and debt restructurings.

Governor Rajan is right, that volatility could lead to a re-evaluation of opportunity and allocations and India will emerge a winner in the event.