Mar 18, 2019
“While we are in an industry that often blends art and science, our preference is to have a strongly objective, scientific, and quantitative bias to our work.” – Martin Zweig
We’ve had a non-consensus, cautiously optimistic view on equities since the beginning of the year, and going further back to Oct 26th (commentaries here, here and our 2019 outlook here).
Healthy Market Internals and the Pain Trade
A meaningful 15%, 1,500 point rally has ensued in the Nifty 50 since then. The market’s internals are the healthiest they have been since 2017. First and obviously, dramatic inflows have come in from FIIs. Capitulation by retail has happened, and short covering by the bears is underway. Next, capital sitting on the sidelines that is waiting out the elections, is going to start feeling the pull of runaway equity prices against idle cash. Retail investors are already likely feeling remorse with their decision to exit equities. The market will usually cause maximum angst for the maximum number, and in professional parlance, we refer to this as the “pain trade”, which is underway.
This rationale suggests prices are likely to stay elevated. Timing the market is never easy.
Large Caps Continue to Garner Huge Inflows
We sliced the data to identify whether there has been a discernible pickup in mid and small cap volume. Alas, this remains a large cap dominated market, as the chart above demonstrates. One thing to note is that the bulk of the market, past stock number 250, is characterized as small cap. Therefore, mid cap volume represents only 100 stocks under the new classification.
A Tiny Pickup in Small & Mid Cap Volume…and Strong Volume Inflows to Large Caps
Volume remains concentrated in the largest 100 large caps. 60% of that volume is coming into the top 25 actively traded stocks. Meanwhile, the pickup in small and mid cap volume in the recent rally has been, in our view, dismal but nevertheless, enough to move prices.
Significant Domestic and Foreign Capital Will Enter the Markets Should the BJP Post a Victory
The satta market is factoring in a BJP victory. They’re generally accurate in their predictions. They have to be. While the smart money entered the market in October and February, substantial capital is likely to commit post elections.
The Third Type of Investor and Wealth Creation
In our view, there are three types of investors out there today. First, there is the small retail investor that has capitulated and pulled back or exited. Second is the “smart money”, usually FIIs and savvy institutional veterans. That money has been buying Indian equities.
Finally, there is a third investor…the investor that has owned quality growth stocks over a period of years, and these investors are uber rich, sitting on generational wealth creation. These individuals are exceptional, as they obviously have to be, in their ability to accept volatility, regularly keep investing, buying quality, and staying invested.
The Third Investor Approach to Capital Deployment for Wealth Creation
So the right question today, isn’t whether one should stay on the sidelines until elections. Rather, the right question in our opinion is how do I elongate my time horizon, stop focusing on the short term, buy quality growth, and regularly deploy capital, particularly during painful sell offs when blood is flowing on the streets.
Global
A Paradigm Shift by the Fed and the Second Largest Inflow on Record in the U.S.
There’s been a sharp rally in the U.S. markets as well. The bears have thrown in the towel. Investors bought a whopping $27.26bn of US stock funds and ETFs in the week ending March 13th. This is the second largest inflow on record, behind $38.30bn in March 2018. The U.S. market has also witnessed declining treasury yields, new highs in high yield, and new lows in volatility.
There has been a paradigm shift by the Fed. The Fed put is alive, QT is dead, QE is probably on its way back, as are rate cuts. Real rates have dropped to 11 month lows.
Outlook
Equities
A Potential Five Year Growth Cycle Ahead But Challenges Need to Be Managed
Growth, demand and inflation remain attractively positioned, but challenges remain. Front and center is the stress in the PSUs, secondary NBFC, developer and housing finance. Most importantly, the stress does not appear systemic, but remains embedded in pockets of the market and will be a drag on economic growth and need to be addressed.
The Macro Climate Remains Favorable
Worries about the Fed and the yield curve have receded. Global trade has plummeted but should recover in coming months. Key indicators for India remain healthy, namely, credit growth, services growth and manufacturing, while inflation remains low. These, for us, are the pillars of the consumptive economy. The RBI remains pro-growth and ready to come forward with rate cuts. Crude oil is obviously a risk and a volatile input that is geopolitical in nature.
The ECRI Weekly Leading Index Has Started to Tick Up…
…While the Conference Board U.S. LEI Is Indicating a Slowdown But Not a Recession
Mid and Small Cap Performance Has Barely Reversed, Large Caps Remain the Foundation Stone
Mid and Small Caps have outperformed Large by 3% and 7% over the past month respectively but remain underperformers over longer periods up to three years.
Mid and Small Have Finally Outperformed in the Past 1 Month…
Those worried about the U.S. expansion growing long in the tooth should look at 1981 to 2000, and 1950 to 1970. Those were the previous secular bull markets in the U.S, both lasting 20 years, while secular bear markets lasted approximately 10 years, the 1970s and the 2000s.
A case can be made that today’s valuations are justifiably high due to structurally low inflation and a very long stable cycle of growth, structural reforms ahead. We’re willing to buy that argument. Earnings will need to come through.
Our strategy remains centered around quality growth at reasonable prices. For risk averse equity investors, large cap portfolios will withstand volatility better, and deliver attractive returns. For moderate to aggressive investors, portfolios with some diversification across capitalization, makes sense.
One Fund That Has Delivered Alpha in Both Bull (2017) and Bear Markets (2018)…
Incidentally, 2018 highlighted the lack of alpha generation prevalent in the industry, and beta masquerading as alpha. One large cap fund, however, the only one in the publicly listed PMS universe with a track record of at least three years, outperformed the Nifty 50 by at least 2% in the bull market of 2017, and then again in the bear market of 2018. That’s a fairly reasonable hurdle to cross. That one fund is our large cap PMS, Sanctum Olympians. It’s equally tough finding a mutual fund that managed to deliver the same.
Sectoral Strategy
There remain implications of slowing growth for export oriented sectors. Information technology could be impacted, as could Health Care and Specialty Chemicals. We own no health care in either of our funds today, and own market weights in Information Technology, in names with structural demand offsets.
Export Oriented Sectors Could be Vulnerable…
Fixed Income
Envisioning Election Outcomes
It’s time to start envisioning a post election environment. Should a BJP victory come forth, we can expect a spike in market spirits. Consumer and business confidence will rise, as will foreign investment, consumption and even that ghost of recent times, private investments, could finally come forward.
Starting with a low CPI, one would expect a rise in growth accompanied by a slight rise in inflation. In this scenario, a reasonable forecast would be steady interest rates. Tailwinds from low inflation, inflows, a steady currency and rate cuts, look likely to be offset by government borrowings and the fiscal math, crude, rising consumer sentiment and a pickup in demand. This remains our base case.
However, an alternative scenario with an alternative party coming to power could be a reasonably different scenario. One could expect slackening oversight and rising inflation, alongside growth, compressing real returns.
Global Policy Response Remains a Key
Globally, we’ve moved to a world where we’re looking at a synchronized slowdown, with Europe looking decidedly weak, U.S. mixed but still in growth and China looking weak. What matters will be the policy response from central banks.
From Synchronized Growth to Synchronized Stimulus
With the Fed done raising rates, and QT in the books, we’d expect a reasonably attractive environment for treasuries in the U.S., stimulus in China, Japan and Europe. Chinese policy seems focused on liquidity and credit stimulus, the ECB may soon do the same. Synchronized stimulus of this nature is positive for EMs, positive for EM currencies, and positive for EM risk assets.
A Growth Oriented RBI at the Helm
How this plays out will only be clear post elections. Should stress build up in our domestic system, we’d expect the RBI to aggressively backstop the system. Monetary policy is likely to remain growth focused, but whether the pro-growth stance extends beyond elections remains unclear. The government will look for a long term solution to address the issue. Private equity could step in. Haircuts will need to be taken by reckless lenders. We don’t see visible, tangible, systemic risk but there could be volatility and a shakeout.
A Stable Currency
Should the BJP win, there could be a flood of inflows into Indian markets, which makes an appreciating Indian currency an attractive entry point for investors. Alternatively, a stable currency with an attractive yield in the 7-9% range would also attract foreign capital.
In the shorter term, we continue to prefer liquid, ultra short, low duration, higher quality assets until risks clarify. For those willing to accept some volatility in their fixed income portfolios, corporate credit in AAA corporates can be considered, which are offering 100 bps above G-Sec in the 2-5 years maturity bucket. We’d stay clear of credit risk funds until liquidity returns to the system. With uncertainty around the fiscal deficit, duration remains a challenging call. For conservative investors, liquid, ultra short, low duration, higher quality credit remains our preferred orientation.
Technical Outlook
The Nifty50 rallied by 3.55% last week to close at 11,427. It was a large cap led rally as broader indices BSE Mid and Small Cap which gained 2.48% and 2.12% respectively, underperformed the benchmark index. Nifty has seen breakout after a three and half months of consolidation in the range of 10,500 -11,100. The breakout is with strong momentum indicated by long body bullish candlestick on weekly chart. Now immediate move for index is seen at 11,520-11,600 and the next move at all-time of 11,760. On the downside immediate support is seen at 11,310-11,275 and the next one at 11,100 levels. In Nifty options, maximum open interest for Puts is seen at strike price 11,000 followed by 11,200; while for Calls it is seen at strike price 11,500 followed by 11,400. Put writing was seen in immediate strike price; while Call unwinding seen in the money strike and writing in out of the money strikes thus, suggesting supports are shifting higher and opening of higher levels. India VIX has increased by 4.7% to close at 15.86 after Friday’s volatility. Going forward expect VIX to remain at higher levels as market heads into General elections.
