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Back into Bull Mode

It has been a long time, a really long time. This May, after so many years of either sitting on the sidelines or occasional rangebound trading, I felt like the bull I was during the time of my blooding into the stock market. It was a moment when I reviewed my entire portfolio and felt that in spite of the recent gains there was only one way, up. After years I feel hope; and the market echoes my sentiment.

The reason I am so bullish on the new government is that unlike the previous one which took no decisions, this one is almost sure to be decisive. The previous government either took no decisions or took terrible ones with major scams unearthed quarter after quarter. The sense of relief on its departure itself is so great that I can’t see a resumption of the bear market under any condition. As I expect the government to do positive work with focus on the essential old economy sectors, I feel that we are going to have a secular multi-year bull run. Retail investors should make use of the first dip they get. They are unlikely to get many.

Current market conditions

The Sensex has been rallying for some time. The Sensex has been rallying since Autumn 2013 but as its composition is heavily skewed and is not really a good indication of the market as a whole, I viewed the rise of the Sensex with cynicism. Only now, in May with the sectoral laggards in large cap, midcap and small cap indices finally moving decisively, we can say that we are in a secular bull market. In the past few trading sessions, we have finally seen midcaps and small caps tying with large caps on percentage gains. The market is green across the board. Selling on news happened only to a limited extent on result day with the Sensex paring down gains as the day went on. We are no longer seeing buying on news. We are seeing buying on expectations.

BSE midcap finally cathes up

S&P BSE midcap finally catches up

As is clear from the chart, the Sensex (green line) has considerably outperformed the BSE midcap and it is only in May that the midcaps have begun to outperform.

Around 10th of May, when I was wondering whether to book profits before the elections, a look at non IT, pharma, FMCG,auto and financial part of the portfolio clearly demonstrated that the profits existed only in those sectors that I just excluded. Elsewhere, multi-year losses were only being partially recuperated.  The stocks in manufacturing, energy, infrastructure, engineering, metals were finally looking alive but they did not seem like star athletes. That has now changed with the rise of these stocks being meteoric in the last few sessions.

A Pause?

However, the market’s movement in the afternoon today (26th May) suggests a pause or partial rollback of the action. The Sensex ended flat but in the green but prominent midcap indices were all down. This is more significant considering the fact that these indices were significantly up in the morning. Many stocks reversed 5% upmoves to end 5% down. This is a likely signal for the profit taking that many of us bulls have been waiting for. We may still see the change of leadership baton to the large caps which could take the rally further but it is more likely that we will see the Sensex and Nifty consolidate or move downwards. Even if the large caps do make a move, it is not going to be a large one. The bull market needs either a price correction or a sideways consolidation phase in order to create strong support levels for stocks to rally from.

 

Todays's steep afternoon drop

Todays’s steep afternoon drop

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Invisible Carnage

On 2nd August 2013, the BSE Sensex and the Nifty closed at 19164 and 5678 respectively. These levels are similar to average market levels of the past year. The Sensex has maintained a tight range between 18500 and 20500 from September 2012 in a movement that may have been irritating for recent market participants who wished the indices to move upwards. I have been feeling that 19000+ is actually a dizzy level considering the actual fundamentals of the Indian economy ( refer my previous article: Markets at 16000 again’).

However, a closer look at the actual market today has managed to shake me out of this illusion. The market is nowhere near highs. In fact it is very much competing with the intermediate lows of the bear market.

Decoupling: S&P 500 and the Sensex

You may remember the infamous decoupling theory of 2007-08. The theory suggested that the Indian markets were decoupled from international markets because of the fundamental strength of the Indian economy and so would not be affected even if American and European markets burned. The theory thus argued that the Sensex could be bought even at 20000.

As the events of 2008 bore out, nothing could be further from the truth.

However, since the beginning of 2013, we have witnessed part of the premise of the theory coming true; Indian markets have decoupled from US markets. Look at the chart and you will see how the S&P and the Dow have been steadily climbing up a mountain while Indian markets have been taking a saunter along the beach.

The Sensex loses badly, very badly

The Sensex loses badly, very badly

Mid caps and Small Caps get smaller still

The two year chart of the Small Cap index demonstrates how Midcaps and Small Caps have dropped sharply whenever the Sensex has fallen but by much more and they have also fallen when the Sensex has only been flat.

The bottom has dropped out for small caps

The bottom has dropped out for small caps

The BSE Small Cap Index has fallen from 13400+ in Jan 2008 to 5178 today. This is only 90% higher than March 2009 lows. The Sensex at 19000 is 140% above March 2009 lows. The BSE 200 is 120% above the lows which seems to be a good performance. However, bear in mind that in times of correction, midcaps and small caps fall much faster and so have much lower bases at historical market lows. Midcaps and small caps are supposed to give greater returns over the long term than large caps. How is it then that we see the Sensex beating their returns so spectacularly?

One chart that shows it all

One chart that shows it all

Illusion behind the Sensex

The level of 19000 too is just an illusion that quickly disappears when we see the stocks that are responsible for keeping it at that level. As it turns out, the only heroes of the index have been in FMCG, IT, Auto, Pharma and HDFC (sorry to place sectors and stocks on the same plane but HDFC and HDFC Bank are a class by themselves). From middle to low levels in terms of weightage in the Sensex, they have risen to the top. Having ITC at max weightage in the Sensex was unthinkable two years ago.

Blood on the Trading Floor

Traditional brick and mortar companies are down to multi year lows across the board. Look at SAIL, BHEL, Hindalco, GAIL, ONGC, RIL, HPCL, Tata Power, Power Grid, NTPC, Tata Steel etc. Look at banking: SBI, Bank of Baroda, Bank of India etc. A behemoth like SBI is struggling at its December 2011 support level of 1600 below which it only has the March 2009 bottom of sub 1000 levels to fall to.

SBI 2 year chart

SBI 2 year chart

For midcaps and small caps, pre 2007 levels have returned and many supposedly strong stocks have given up decade long gains. It is almost as if 2004-2007 had never been. The list of stocks is too long and too painful to read out so all I am telling you is to take a look at almost any midcap in the engineering, manufacturing, mining, power, metals, fertilizers, banking, realty, textile, media space. In fact, look at anything other than IT, FMCG and pharma.

The premises of every wealth manager who has talked of investing over the long term for better returns have come to nought.

The FMCG bull run has relied on the strength of India’s consumer based economy but this cannot last forever as consumption in a bear market economy is not the same as consumption in a booming one. The auto sector is already learning this.

The writing on the wall is clear. We are in a horrible, horrible bear market which is better represented by 12000 on the screen, not 19000.

It’s All About Liquidity,Stupid!

Image

The Nifty has crossed 5500 and the Sensex is at 18300. There may be no core fundamentals backing a rally of this magnitude but that does not matter. As I wrote in my previous article, we are in a purely liquidity driven rally.

However, this rally has also taught me a lot in addition. First of all, rallies are powerful only when driven by liquidity, not fundamentals. Fundamentals play only a supporting role. The Fed’s unleashing of liquidity in 2009 kickstarted the recovery from the lows. The ECB’s unleashing has done it now.

It doesn’t really matter if there are no fundamentals because when money is cheap, risky assets like stocks will move up. It is also true that the markets will fall but that will happen not because of waning fundamentals but waning liquidity. Go back to 2008 and you will see that decreasing liquidity preceded the fall and the bottom was reached at the time of the worst liquidity crunch in a long, long time.

When there is a clear trend in stock markets, fantastic money is made in a very short time frame. However, then the fall, consolidation etc. comes which tempers the long term returns significantly. Thus as the time in the markets increases, the returns become far less impressive. We have witnessed a 20%+ rise in the benchmark indices and more in the midcap indices. People have made more much money in this time frame than investors have made in four years(even not adjusting for inflation.

The very long term is supposed to belong to fundamentals but that is entirely a function of the point at which the investor is evaluating his investment. Companies with great fundamentals languish at lows because there is no buying interest (no liquidity) while bogus companies run up like crazy.

The fundamentals basically are needed to sustain a stock at higher levels otherwise it falls when liquidity dries up. However, when liquidity for the entire market dries up, even strong stocks fall rapidly and so one can avoid losses only if one has entered at lower levels.

In toto, better to play liquidity for market trends than fundamentals. As long as liquidity continues to flow in the financial system, there will be no correction in the Indian bourses.

Steroids Take The Sensex Into Orbit

The month of January 2012 seems to have descended straight out of the good old days of 2003-2007. With the Sensex trading at around 17500 and the Nifty near 5300, nobody is remembering the bearish days of December. There has been more than 12% gains in the benchmark indices and much more than that in individual stocks. Even midcaps have rallied. So is this really one of the sunshine months of those wonderful years?

Like the mid 2000s?

Only partly. The part which does agree with that period is liquidity. In those years, the markets were awash with funds, funds which were responsible for the stock market and commodity market bubbles worldwide. We saw how liquidity changed sentiment when Bernanke released QE1 into the markets in 2009 leading to one of the fastest pullbacks ever in equity markets. This flood of liquidity is back and is showing no signs of ebbing. FIIs put over 10000 crores in Indian markets in the last one month and are putting in more each day.
Another common thing is that people have been wringing hands as they have been unable to get in. There is money on the sidelines that is jittery and likely being deployed at ever higher levels.
However, apart from that, there is little in common with mid 2000s. The market fundamentals are very weak and the markets are looking quite expensive. There has hardly been any significant positive news to justify the price increases. Europe, US, China and India: all four have growth problems in descending order of magnitude. The actions in the US and Europe have been to brush the problems under the carpet and in fact there has been no effort to really solve the intrinsic problems of the economies. The mid 2000s were based on real earnings increases which were sustainable in the long run (the absolute earnings being sustainable, not the increases).

Another big difference has been in volumes. Cash market delivery volumes are nowhere near levels which were common in those years. Retail investors continue to stay away from the markets. A bull market rally rarely runs on small volumes. That is more the characteristic of a bear market rally.

Liquidity: the ultimate steroid


The markets are on steroids and steroids as any doctor will tell you are very effective and powerful. Forget fundamentals, the Sensex could even take out another 1000 points on this rally. There is after all, no resistance on the upside as people are too scared to short. You see, the absolute absence of fundamentals in this rally gives it the feel of a pure momentum play and it is foolish to go against pure momentum plays. You could book profits in pure momentum plays, but should never short them. It is evident in the interviews of ‘market experts’. These experts are increasingly unable to justify prices as the problems of December still remain in a big way yet have nevertheless been coming out with buy lists. These lists too are heavily focused on momentum plays.
The good doctor will also tell you that steroids are bad in the long run because of significant side effects. Secondly, steroids are used only temporarily to support a diseased body. The cure never comes from steroids. I maintain what I wrote in my earlier article, (Markets at 16000 again) the Sensex does not deserve these levels.

Trading strategy

In end 2007, it was clear to many that markets had run ahead of fundamentals. This was clear even at 17000. People who sold out at these levels rued their impatience as they saw the Sensex rallying all the way to 21000. They were vindicated but much later, in January 2008. The call which one is to take is whether to risk selling out early or risk taking big cuts when prices inevitably, fall. What is to be clearly avoided is putting in fresh long-term money at these stages.
The buyers who have bought early on and who are guiding the market through their buying need liquidity to exit at high levels and by producing a one way move they have succeeded in drawing loads of traders back into the market. These traders will be left with uncovered positions the day the market tanks. It is clear that when it does tank, the cut will be savage. I feel a 300 point cut on the Nifty is not out of the question.
If one is to participate in a bull market, participate in the genuine bull run in precious metals. I will write on that soon.

Having said all this, the sheer amount of liquidity means that one can still take a call on the market purely from that perspective. The market is showing all the signs of a healthy bull market. The 300 point cut could also come after the markets hits 6000+. So, it may be prudent to play smart and participate in the rally as the music may continue for some time yet.

Disclaimer: To some extent, I was caught on the wrong side of the rally but am covering ground with fresh investments. I have also gone long on gold and silver.

Markets at 16000, again!

16000. The figure invokes a very strong sense of déjà vu. We’ve been at 16000 once in 2007, thrice in 2008, twice in 2009, twice in 2010 and four times in 2011. The level has acted as a support for the market many times, most notably in 2010 when the market rebounded sharply both times it hit 16000. Support is the technical term but what it really means that the market found enough suckers to buy the market at that level.  Someone who bought into the Sensex at 16000 in 2007 has made no money for more than four and a half years. This level is almost 25% below the Sensex life high of 21000. At such high levels, the logic which is sold to investors for long term investment is that one should not look at the trailing twelve month P/E but the forward P/E. The forward P/E projection is usually 20-25% higher which is used to imply 20-25% growth in value of the index.

Going by this logic, an investor should have got 20% returns YoY since 2007 instead of zero or negative. Why has this not happened?

EPS: an analyst joke

Ignoring market gyrations, I will simply state the most basic reason. The Sensex has been overvalued for the past several years. EPS growth has never been even close to the levels predicted by analysts. In Jan 2008, Citigroup said that the Sensex at 21000 was trading at 22 times forward P/E. Thus they were predicting a Sensex EPS of 955 for FY09 (by the way, they had a Sensex target of 23950-25000 for the year.) Even 1000+ estimates were made by some. The actual EPS after twelve months was 792. The funny part is that the figure of 955 is the current EPS of the Sensex according to bseindia.com(13 January 2012 with Sensex closing value of 16154.62 and TTM P/E of 16.91. The data from NSE suggests a higher Sensex EPS for the twelve months ended Sept 2011 at Rs.1013. Citigroup like many other analysts had projected extreme bull run conditions into the future.  This is a recurrent phenomenon which has been seen this year as well. Bloomberg consensus estimates for Sensex FY12 EPS were at around 1250. I would be surprised if it achieves 1050.

Conflict of interests

These consistent overvaluations are not a mistake but part of a very concerted plan to lure gullible investors who are stupid enough to believe in ‘finance experts’. The models of these experts are so complex and they consider so much data that they give themselves and investors the illusion of actually knowing the subject. Yet, their own traders are unable to beat the market and their clients lose money. Guided broadly by some fundamentals, the markets then rally mostly on sentiment. The job of the analyst is to disregard this truth about sentiment and to justify every valuation in the park, howsoever absurd. That is where the expertise of the analyst actually is needed. When the market fell to below 16000 in one day of panic selling on 22 January 2008, everyone on CNBC was shocked at the extent of the cut and advised ‘long term investors’ to enter into the ‘correction’. It was good strategy as people liquidating positions had to sell to somebody and these idiotic comments were as much denial as malice. These comments to buy petered out by the time 10000 was on the Sensex which was the actual level to enter. Why I call 10000 as the entry point instead of 16000 is simple. Sensex TTM P/E in end 2008 was 824. Even if we assumed positive earnings of 10% instead of the actual negative 10% we would have come across 900 forward earnings for FY10. At a forward P/E valuation of 15x, the Sensex should have still traded only at 13500. However, the figures of 15-18x are usually used in bull markets. By the PEG theory, forward P/E should equal EPS growth. This would have implied fair value of the Sensex at 10x or 9000. I wish I was smart enough to realize all this then and had bought bucketloads of stocks then. The point I wish to make is that the livelihood of the financial companies depend heavily on the capital markets. Market over exuberance is extremely profitable as it leads to tremendous growth of the financial services industry. Senseless valuations and forecasts are much more profitable than sober ones.

Ramping up prematurely

On fundamentals, the market should never have touched 21000. It did not deserve the level then and does not deserve it today. It did not deserve 18000 either. The move up to these levels has only benefited a few traders and financial ‘experts’, giving them the license to make idiotic charts that project irrational returns. In the long run the market has survived at neither of these levels.Even when the green shoots were clear in 2009-10, Europe was a concern that had the potential to explode any time. From this time to mid 2011, analysts once again utilized the opportunity to profit from gullible investors by selling them products at 18000 and 19000 Sensex levels by nicely showing them charts of twelve month returns. Of course at these levels neither the debt crises nor commodity based inflation was priced in. They were back to the forecasts of yore projecting 25000-30000 for the Sensex as the ‘India growth story’ is still intact. The India growth story has been a much abused term. It was responsible for the decoupling theory of 2007 that famously predicted that Indian markets would not at all be affected at all by the subprime crisis.

Strategy of fooling long term investors

The analysts will never tell you that markets are not sexy. That would negatively affect their profession. The big investors, funds and brokerages always try their best to profit at the expense of the public. At the end of the day, the public is the one holding stocks at the highest levels. The brokerages quietly sell out in the rallies, the rallies themselves being engineered. As engineered rallies are costly to sustain, the the index retraces its gains after some time. Carefully observe the Sensex yo-yos in the last few years. You will observe a lot of trading ranges. These ranges have usually been broken on the downside in spite of consistent buy calls from brokerages. However, the public is left holding stocks from the highs of these rallies. If the institutional investors actually sold without creating artificial rallies, they would create precipitous declines. Instrumental in the artificial rally is the role of the momentum trader. No wonder that India’s stock market trading volumes are the highest in the world but the cash market volumes are in single digits. These artificial rallies have terribly low delivery volumes. When these rallies peter out, the value or long term investor is exhorted to save the skin of the large institutional investors who wants to sell without creating selling panic. These market manipulations are centuries old and still manage to find fresh losers.

The Future

If we assume 1150 as the Sensex EPS twelve months down the line, a valuation of 12x suggests fair value at 13800. Do I suggest buying at 13800? Yes, but only if you are not invested at present. Besides, a crack to 13800 could as well send the index crashing to 12000. My reluctance stems from the fact that Rs 1150 on a base of 13800 yields 8.3%. Risk free interest rates are at 9%+. Thus, unless we officially believe in monkey forces and the greater fool theory, there can be no justification for investing even at that level. I wholeheartedly believe in the greater fool theory as it has been the primary mover of Indian markets in the last five years but it is a theory only for traders, not for investors. The recent rally in the Sensex of 1000 points is in my opinion, nothing more than a suckers rally. Even if the index rallies to higher levels, there are no real fundamentals for an extensive bull run. A move higher would continue the long term bear market and draw more losers at higher levels (this is exactly the opposite of what a technical analyst will claim.) There has to be a change in fundamentals for a bull run. Look at the problems in Europe, US and now China. Every positive development claimed such as improvement in US GDP growth and unemployment numbers has only short term relevance as the underlying debt and related concerns cannot be wished away. China has had a huge real estate bubble and the voices of a soft landing following the bubble burst sound so 2007. I was a big bull from 2004-2008 but have been a net seller since May 2008. Secular bull runs start from compelling valuations, not from fair value or marginally overweight valuations. Bull runs are scripted in graveyards.

References:

http://www.moneycontrol.com Sensex Target of 23950-25000 in 2008 – Citi http://www.dalalstreet.biz/investor/2008/01/sensex-target-of-23950-25000-in-2008/
http://www.dalalstreet.biz/investor/2007/06/bse-sensex-forward-pe-chart/
http://capitalstock.wordpress.com/2010/09/10/mystery-of-sensex-eps/
advfn.com
Business Standard
Reminiscences of a stock operator by Edwin Lefèvre
equitymaster.com