The jury is still out on whether the current surge in equities is the start of a roaring bull market or just another big bear market rally. The stock market's volatility and concerns about Europe's deepening financial crisis signals investors should remain cautious.
However, the market’s price structures are telling us that something different is going on, says Ridham Desai, managing director of Morgan Stanley. "The number of stocks that are crossing their 200-DMA is the best that we have seen since 2007 and that doesn't usually happen in a typical bear market rally," he highlights adding, "it tends to suggests that a few stocks are really making a turn for the better."
Desai says the pace of the upmove suggests that the market is approaching a golden cross probably in March. "The last time we saw a golden cross on the way up was March 2009 and that sounds very familiar because in March 2009 fundamentals looked fairly bleak and then in the subsequent two months there was much greater optimism on fundamentals,” he recalls.
"We have hopes here that this is a new bull market," says Desai.
Below is an edited transcript of Desai's exclusive interview on CNBC-TV18. Also watch the attached videos.
Q: Do you think it's a bull market? I know it’s a tough question but what’s your gut feeling?
A: The jury is out. The market's price structures are telling us that something different is going on. We have had a fair many of rallies in the last few months. We have had a few very big rallies. People have been wrong footed on them and then the market slipped back and found a new low every time. This time it seems that the price structures have changed. For example, the number of stocks that are crossing their 200-DMA is the best that we have seen since 2007 and that doesn’t usually happen in a typical bear market rally. It tends to suggests that a few stocks are really making a turn for the better. The market itself has sustained over 200 DMA now for several days like it did in March 2011.
Remember, it did that in March 2011 and then came right back down. So, that's again is an interesting price structure. What I am focused on is the golden cross, which is, when a short-term moving average crosses the long-term moving average, and for longer term market cycles we use the 200 DMA and the 50 DMA. I think a lot of fundamental analysts will frown at this that I am suggesting a technical tool to discover whether this is a bull market or not. However, the genesis of that is usually share prices lead the turn in the fundamental cycle and there is a state of denial on the fundamental cycle.
At the current pace, at which the market is moving, we will actually get a golden cross in early March. And if you go back the last 20 years on the Nifty or the Sensex, those occasions have coincided with a turn in the fundamental cycle. The last time we saw a golden cross on the way up was March 2009 and that sounds very familiar because in March 2009 fundamentals looked fairly bleak and then in the subsequent two months there was much greater optimism on fundamentals.
If you go back further then the previous time it happened was July 2003. In the 2003 cycle, the markets were cheap like they were in December this time. There was a lot of liquidity sloshing in the system and suddenly equities rose up 30-40%, without a blink, and most people denied it saying that the fundamentals look quite shabby and there are no reasons for this to happen and then in 2004 fundamentals started to change.
So it is quite reminiscent of that but I tend to agree with you that jury is out. We can’t be absolutely certain that this is happening. I can’t put my head to work. I have to put my heart to work and it seems like we have hope here that this is a new bull market.
Q: Let me ask you about 2003 example then. What typically happened? The first move everybody missed. After that did the market turn and give you another opportunity to enter or was that entry opportunity many months later and at a price point, which was significantly higher than the starting point?
A: It was certainly a lot higher because, if I remember correctly, the Sensex started at 2,800 or so in April of 2003, went all the way to 6,000 before it actually gave its first correction. So the markets actually doubled, which was a big miss, but then if you see the subsequent bull market, it didn’t really matter if you bought it at 5,000. You still quadrupled your money in the subsequent four years. So, you still made a lot of money and stocks went up 10-20 times even from those levels. I don’t think we are dealing with a same type of depressed valuations.
So, if I were to spoil the party for the bulls, I’ll draw their attention to two facts. The valuations that we saw in December were a good 30% higher than we have seen at previous bear market troughs. So they weren’t actually the cheapest valuations that we have seen at bear market troughs, including 2003 and 2009. The second thing is that the price fall that we saw from the previous peak, if we reckon that the October 2010 was kind of a bull market peak, which again is subject to a lot of debate, whether we actually had a bull market between 2008 and 2010 or it was just another bear market rally from the bear market that started in 2008, it was only 25%. Whereas, historically, the market is usually halved from the bull market top to the bear market bottom. So, it did not really face that type of severe price correction that we have seen in previous bear markets. So, those two are party spoilers—if I may put them that way.
But again this is up for debate. I mean was the market peak of January 2008 the bull market peak? Did we see a new bull market, which was a very short one, between March 2009 and October 2010? Or was this all a part of a big bear market where we saw big trading rallies and then final trough which was actually higher than the December 2008 trough but it was probably the proper time correction that we should have got from the excesses of 2007?
So that is hard to tell and only time will tell what actually happened, but we did not hit the valuation lows of previous bear markets for sure.
Q: That makes you suspicious?
A: No it doesn’t make me suspicious because we don’t have to get there. A lot of other things fell into place. The sentiment was really bad and usually that’s a key ingredient. The positioning was very feeble. That’s another key ingredient. I think people had given up on equities as an asset class.
Indeed in 2011 we ended the year with negative real returns on equities, which were the worst in India's history apart from 2008, which was a very abnormal year. So I am taking the absolute returns, which we all know were negative, but on top of that we had fairly high inflation. So when you plot the negative real returns they were really bad. In fact, the five-year CAGR on equity returns by the end of 2011 were negative on a real basis, which has not happened in India's past.
So it was certainly a very bad market and I am talking here only about the Sensex and the Nifty. The broader market was in much worse shape. I would say quite a few ingredients were in place though valuations were not precisely there and that’s again a question of using Nifty, Sensex versus BSE 200 and a broader market valuation matrix, which was a lot cheaper. The hit on the broader market was a lot deeper then the narrow market. So may be that’s the right valuation matrix.
Unfortunately, we don’t have too much history on those matrixes to be able to tell what happened in 1991, what happened in 2003 and that is why we keep going back to the Sensex. So a lot of things were in place. It could have been a trough that may have formed the bear market bottom and then we may be in a new bull market.
_PAGEBREAK_
Q: What about sentiment and positioning? What are they telling you now? Typically, when a new bull market starts off the first few months, sentiment is still in denial, positioning does not change dramatically. Are you seeing that with your clients that people are saying this is not the real thing?
A: Yes. I don’t think people believe that this is a new bull market. They have obviously reconciled to this being a very powerful rally, which they may have missed. They are hesitant to participate. Most of the voices I hear say “the longer it lasts, the bigger is going to be the fall and the higher it goes up the deeper we are going to be in trouble”. They very quickly point out a few negatives on the way.
It’s so easy to paint a bear case scenario, which is why we have to be doubtful about it, because it’s so hard to actually paint a bull case for this market. So let’s discuss the bear case. It’s so easy: Europe will falter again and that can happen tomorrow morning. It may happen even before this goes on air. You never know. Oil can go to USD 130-140 a barrel. What stops that from happening? It’s not too far away. It’s already kissing USD 120 a barrel, which is again a big problem for India. Policies may not make any move. There is some promise on the horizon but then we have had such promises for successive months and every time we have been failed on that. We may not get a credible reduction in the fiscal deficit, which may not allow the central bank to follow through with rate action, which surely the market now is expecting.
So I think it’s very easy to paint a bear case scenario. What about the bull case? It is very hard (to paint a bullish scenario). Valuations are middling now. The market has rallied 20% from the lows, so the valuations are no longer as cheap as they were in December. You would say, positioning is still feeble and sentiment is still weak but earnings look so bad and there doesn’t seem to be any sign that they are going to turn around. If anything it looks like earnings are going to remain weak for the next four-five quarters if I were to believe what the consensus is talking about. Therefore, it’s hard to paint a bull case scenario and that makes me more suspicious that we maybe in a bull market.
Q: Do you think, generally, if this is a bull market then it will climb those walls of worry that you just spoke about?
A: Yes. I think bull markets like to climb walls of worry. It could happen. The way this works itself—let’s paint the bull case scenario. So, how does that work out? The way it works out is that share prices rise and as share prices rise it opens up capital markets. Companies get to fix their balance sheets because one of the problems of the last three years is that we have got lot of pain in the tail end of the market. So these balance sheets start getting fixed.
We are seeing signs of that. We have seen a lot of block trades happening in the market. We have seen some new capital being raised. So the window is opening up now again, which was not the case in almost for the whole of 2011. So as capital gets raised, companies fix their balance sheet and that automatically creates demand in the economy because that allows companies to spend capital, demand recovers and you get a virtuous cycle. So there is a lot of reflexivity here which is the way the world operates. Higher asset prices lead to higher growth and vice versa. It could be just another reflexive cycle, which gets us out of the hole.
I would argue that India’s underlying economic dynamics even through the last three years of visible pain have actually remained fairly solid. We are not in such a bad shape as share prices would have projected in say 2011 and what happened in December 2011 think made things look far worse then what they were really on the ground. If you break up the economy into various parts, really the most intense pain that we are facing is with respect to private capital spending, which is basically manufacturing capex.
I am not surprised at this happening because in the preceding five or seven years, manufacturing capex grew at such a stunning rate that it has to go through some consolidation. We have done some work on the top 200 companies in India. The asset turn is down 30% from the 10-year average. It’s not just down 30% year-on-year it’s down 30% from the 10-year average, which tells you that the underutilisation of assets is fairly high and it’s actually at a high point compared to at any point in the last 10-years, which means that you have got a lot of excess capacity sitting in the system which are depressing your margins and that’s not going to incentivise anybody to spend money on new capacity. So that is where the pain is and that’s what everybody is focused on. But if you look at the consumer, he is pretty okay. The sentiment on the ground is not as bad as the sentiment in the market, arguably.
At least, it wasn’t the case in December now I think things have recovered slightly. The underlying economy is in good shape. If you apply a few changes to this, a little bit of policy, a little bit of rate reduction, a little bit of fiscal discipline and a little bit of capital the growth can recover from maybe 6.5-7% to maybe 7.5-8% or 7-7.5% which is good enough to lift corporate earnings growth from 5-6% to 15%, which is what defines the start of a new bull market. That’s not very difficult to construct but it’s not anybody’s base case today because people are not thinking bull market terms. They are thinking bear market terms. They are thinking what can be the downside risks and as I said those are very easy to paint right now.
Q: So do you think the current optimism in the infrastructure space, which is the biggest dog of the last couple of years, is justified in a sense because of the factors you mentioned?
A: No, actually I would separate the capex thing into two parts. One is what is going to happen on manufacturing capex and one is what is going to happen on infrastructure capex. I have greater optimism upon infrastructure capex. Indeed, I would argue that infrastructure capex has not done as poorly as share prices have done, which is that the headline growth has been good, margins have been bad and there has been intense competition, which is why listed companies may not have won their fair share of orders. There are other problems with balance sheets and other issues for these companies, which have caused share prices to go down. So that’s not necessarily entirely linked to the growth that we are seeing in infrastructure.
Can the growth be better? For sure it can be better. It’s not a bad thing. I think infrastructure growth in India is currently outpacing nominal GDP, so it’s gaining share in GDP. It’s actually got a good starting point and from there I think it will improve further in the next three-four years. Private capex may take a little longer to recover because there is hardly any global tailwind and there is a lot excess capacity in the system which will take time to exhaust and growth rates have slowed down from say 2007-2008.
Obviously, the projections that companies made when they were putting this capacity have been bellied and to that extent it will take a little longer for that to come back.
Q: Let me bring it down to brass tax now. If your client called you today and said, "I have missed this rally. What do I do now?" You have told me your bull case, bear case. Do I start deploying cash today or do I wait for the first meaningful dip? What is my tactical strategy now?
A: I think there will be a dip. It will come. No market goes up endlessly. I think we are getting closer to that correction than we were 15 days ago.
Q: You don’t think it can go to 6,000 and then correct in which case you would be buying even more expensive than today?
A: If you put a gun on my head, I think it is like 5700-5800 coming, so another 5-6%, which is a reasonable amount of upside. My own way of playing this is really by stock picking rather than focusing on where the index is going. I think on the up and on the way down there are reasonable numbers of stocks that you can buy which will deliver outperformance or even absolute returns.
That will be the advice and that’s the advice that we are giving our investors — just stay focused on stock picking. Now, that doesn’t mean that you will just buy quality and low balance sheet gearing or free cash flow as investors have done in the last 12 months or last 18 months. That’s the flavour of the month. I think you buy mispriced stocks where you think that the inherent value is a lot higher than the current share prices. There are still plenty of opportunities even though at the index level they would not appear to be so.
The midcap space gives you tonnes of such opportunities even after this rally. So it doesn’t matter that the Nifty goes up another 300 points and corrects. I think those opportunities keep existing. So you need not wait for the correction as such, but since your question was, “what do you do with the Nifty?” I said maybe you want to wait for the correction and maybe you end up buying at today’s levels after the correction. That’s quite possible.
But there is more psychological comfort in doing that than buying it today and seeing the market fall very quickly. I think the strategy is to pick stocks. It is still one of the market that’s geared for big sector bets. I will give you illustrations as to why I am saying that. For example take banks. Even today I think the SOE banks don’t look out of the woods. I think they still have a problem with their balance sheet. They still have NPL creation, which is faster than what the market is expecting, not withstanding the rally in the share prices. In fact, they become less attractive than they were.
So could have argued, in December they were really cheap, let’s ply the valuations. Today, they are not that cheap anymore and they still have a cycle of NPL to deal with. Private sector banks look in much better shape. In fact if you look at the recent quarterly and in most private sector banks have reported a quarter-on-quarter (Q-o-Q) decline in NPLs and most probably public sector banks have reported a Q-o-Q acceleration in NPLs. So the difference between the two sets is quite stark.
I would imagine that to be overweight financials, you would end up buying both the baskets where as actually I would rather buy private sector banks than buy public sector banks. I think likewise in industrials. In industrials you can buy the infrastructure guys. There is a lot of promise. There the valuations look cheap but the capital good guys I think still have a bit of a problem in terms of revenues and profits because we are not going to get such a quick recovery in capex, at least not in the foreseeable three-four quarters. So, some of these stocks will give back their gains. So should you go overweight industrials? I don’t think so.
You could make the same argument in consumer staples where a few stocks look very expensive and there are the midcap names, which look very attractive, which I think should be bought. I don’t think there is any particular sector where I am interested in being completely bullish and saying that across the board you can buy all those stocks.
This is a market, which is still good for stock picking. It is still a stock pickers market where you look at each sector separately and then say, okay these are the stocks I want to buy and these are the ones I want to avoid. That theme I think continues for now.
Q: On that my last question because if this is a start of a bull market, a lot of people want to play this contrary to popular wisdom. They don’t go for high quality. They don’t go for the good balance sheet kind of stocks. They go for the beaten down balance sheets because that is where the repair will happen and you will get the highest alpha. Some of that has happened in January-February, but do you think that’s a good way of looking at it or playing it for someone who has got a high risk profile?
A: If you look at the market’s statistics, it is actually low beta that generates consistent outperformance over cycles. In fact, if you had bought a low beta portfolio in 2003, by the time you hit the end of 2007, it outperformed the high beta portfolio. So, what we did was we picked up the bottom quintile of beta and went long in that portfolio and shorted the portfolio, which was top quintile in 2003, which was arguably the market low and therefore it made a lot of sense to buy high beta.
That portfolio actually generated better than index returns by the end of 2007 by which time you would have imagined that high beta was everybody’s favourite. I am not even going into 2008 when everything was sold off at the end of 2007. I think there is merit in why this happens, fundamental merit, and this maybe a slight digression here. The reason is that low beta stocks have a much lower hurdle rates. So their ability to beat market expectations is a lot higher. So maybe in a three-month cycle, a high beta stock may deliver returns but it normalises overtime.
So depending on what your portfolio perspective is and what time duration are you buying your stocks for—if you are buying it for three months duration, obviously, you should take the risk and buy beta. But then you should know that it’s a risk and the returns can quickly go away. But if you are buying it for a one to two-year timeframe, which is I think an advisable timeframe for equities, three months is not. Three months is speculation one to two years is investment and then I think it doesn’t matter. Then you buy companies where there is mispricing. Whether the beta is low or high doesn't matter.
The final point on beta is that beta constantly revolves. What was high beta last year may become low beta this year. In fact, in 2011 the biggest increases in beta happened in consumer staple names. The industrial names or financial names show a drop in their beta, so that beta keeps revolving. So I am not a very big beta fan. I am a fan of mispriced stocks rather than beta. I think that's the way you make money. |
India Equity Research Reports, IPO and Stock News
