Do it yourself

Little did Edward A. Murphy, Jr., an American aerospace engineer, realize that one of his design advice would become one of most popular epigrams and be termed Murphy’s Law. In the late 1940s, Murphys told his team that “If there are two or more ways to do something and one of those results in a catastrophe, then someone will do it that way.” This advice was later restated by Arthur Bloch in his book Murphy's Law, and Other Reasons Why Things Go WRONG as “Anything that can go wrong, will go wrong.”

In 1997 Sebastian Junger wrote a creative account of the 1991 ill-fated fishing expedition of the boat Andrea Gail from Massachusetts. The boat was caught in a severe sea storm and all the six crew members were reported dead. The book, titled “The Perfect Storm”, was later adapted into a movie with the same title. ‘The Perfect Storm’ is one of the perfect examples of Murphy's law applying in real life situations.

As of this morning, the Indian equity markets appear heading into a perfect storm. Anything that can go wrong appears to be going wrong. Let’s pray Murphy fails this time.

Economy stuck in slow lane

The broader economic growth momentum has stalled, completely negating the impact of the massive Covid stimulus. After a couple of years of denial, most agencies are gradually acknowledging that the real GDP growth might be settling in the 6%-6.5% band. As the latest Union Budget depicts, the fiscal leverage to stimulate growth has now mostly dissipated.

It is worth noting that FY26BE fiscal deficit of 4.4% may appear encouraging in recent context, but is far higher than pre Covid FRBMA mid-term target. Besides, as per FY26BE interest payments are projected to be 37.2% of total revenue receipts (vs ~23% in FY18RE). Obviously, the present debt and deficit levels are not sustainable.

For record, FY19BE projected fiscal deficit at 3.3%; to be cut to 3% of GDP by FY21. If the government aims to achieve this target by FY29, there would be hardly any fiscal leverage available to the government for increasing expenditure.

The central government capex, as percentage of GDP, may have already peaked around 3% of GDP. Even taking into account the state level capex, the total public capex is now stuck at 4%-4.5% of GDP, with significant risk of slippages due to resource constraints and execution failure.

The scope for increasing government consumption (revenue expenditure) is limited and would depend entirely on the tax buoyancy. The finance minister has assumed an income tax buoyancy of 1.4 in her estimates for FY26BE. This implies the government expects 1.4% rise in personal income tax revenue for every 1% rise in GDP. Even the STT collections, which are entirely a function of stock market trading volumes & MF flows, are assumed to be growing 41.8% in FY26.

Even with these aggressive tax revenue assumptions, government revenue expenditure (ex-interest) is expected to settle around 5% of GDP, much lower than ~7.5% seen during pre-Covid years.

Aggressive tax buoyancy assumptions, despite exempting personal income upto Rs12 lacs from income tax, indicate continued pressure on the upper middle-class segment consumption. This is the segment which has provided material boost to consumption growth, especially in the premium segments like SUVs, premium liquor, travel & tourism, clothing etc.

Despite all the efforts and incentives, private capex for new capacity addition has not picked up. Most private capex in the past five year has been in technology (improving productivity), real estate accumulation, brown field expansions, and consolidation through merger and acquisitions. There have been only a handful of greenfield manufacturing projects. Consequently, the share of manufacturing in GDP has not improved (in fact declined marginally). With sub-optimal consumption demand, positive real rates, and global headwinds on exports, the visibility of any material pick-up in the private capex remains low.

Thus, all the macro drivers of growth (consumption, investments, exports) are facing headwinds. At this point in time, it appears unlikely that in the next 4-5 quarters we shall witness any substantial improvements in most of the growth drivers. However, if the Mother Nature gets angry (a hotter winter, just like the warmer winter this time); or the ongoing global trade war triggered by President Trump gets uglier, the things could worsen further and we may witness growth trajectory collapsing further to pre Covid trajectory of 5-5.5%.

Corporate earnings fatigued

After compounding at a rate of ~18% over five years (FY20-FY24), the corporate earnings appear fatigued. Nifty50 FY25E earnings are expected to grow at a meager 2%-3%. As per the current consensus estimates, FY26E Nifty 50 EPS may grow ~12-13% yoy. However, given the macro headwinds, INR weakness, tariff headwinds for exports, persisting slowness in consumption demand, indicate some downside risk to the current consensus estimates.

The earnings growth in the recent past particularly led by banking, commodities (metal & energy) and capital goods & construction sectors.

Recent performance of the banks indicates that the growth drivers are now tired. Asset quality has peaked for most banks. Any further slowdown in the economy may actually trigger a reversal. Some segments like microfinance, unsecured personal loans and gold loans etc. are reportedly already showing considerable deterioration. Beginning of rate cut cycle with emphasis on immediate transmission, indicates that net interest margins may also be closer to peak and might begin to stagnate or moderate from current levels. Rising stress on household balance sheets, slowing demand for automobile and other consumer discretionary items, and slower private capex growth may keep the credit growth under check. Any substantial improvement in earnings growth for the financial sector in the near term is unlikely.

The demand growth for building material, steel, and other metals has moderated in FY25. The management commentary indicates only moderate improvement in FY26 with continuing margin pressures, given low-capacity utilization and lack of pricing power. Durable tariff by the US, might result in EU and Chinese dumping in countries like India, further pressurizing the domestic prices.

Several mega infrastructure projects like expressway, airports, freight corridors etc. are nearing completion. The pipeline of large infrastructure projects is diminishing in size; and the focus is on completion of the stuck projects. The visibility of large contracts for construction companies, except in the power sector, is poor in FY26 at least.

It is important to note that a large part of stock price rise in the past four years has occurred due to PER re-rating in anticipation of strong earnings momentum. Lack of sustained earnings momentum might result in some PE derating also; while there is no case for a further PER rerating.

Overall, any material upgrade in earnings estimates and PER rerating looks unlikely. However, there is a decent probability of earnings slowdown and PER derating persisting through FY26.

Technical indicators pointing to further downside

With a material erosion in stock prices over the course of the past six months, the investors’ buoyancy has eroded to a large extent. The broader markets with over 20% correction from recent highs are already showing a bearish trend. Benchmark indices are down ~13% from their recent highs and are showing distinct technical weakness – trading below all key moving averages. The technical studies indicate 4-5% further downside from the current levels.

However, if the earnings deteriorate and global noise rises, the immediate technical support may break and markets may head for much lower.

The perfect storm

Deteriorating macro, global headwinds, stagnating earnings growth and PER derating, and weak technical positioning could forma perfect storm for the Indian equities. Murphy’s law says it is more likely to happen. Let’s pray Murphy fails this time.

The first half of the year 2024 has been good for global markets. Despite disappointment on rate cuts, geopolitical concerns, sticky inflation, and political changes in many countries, stocks, precious metals, industrial commodities and crypto made a steady move up with very relatively low volatility.

A notable feature of the global market movement in 1H2024 was the stark underperformance of Asia ex Japan, even though the Japanese equities being the best equity markets amongst the major global markets. Brazil also underperformed despite a decent rally in commodities.

Another notable feature of global markets was the narrow market breadth of US markets. Though the benchmark indices scaled new highs, it was mostly due to parabolic rise in a handful of technology stocks.

At present equity markets appear strong on the back of a resilient demand environment, well anchored inflationary expectations and peak interest rates. Fears of earnings failing to match the stock price rise, escalation in geopolitical tensions, spike in energy prices, uncertainties about the policy direction post the US presidential elections, and erratic weather conditions are some points of concern.

India performance – 1H2024

Indian markets performed very well in the first half of the year 2024. Though Indian equities underperformed the developed markets in line with the global trend, it did very well within the emerging market universe. The key highlights of the India market performance could be listed as follows:

·         The benchmark Nifty50 gained ~10.5% during 1H2024; while the Midcap (+20.7%) and Small Cap (+21%) did much better. Consequently, overall market breadth has been strong.

·         Two third of the market gains came in the month of June 2024, post the elections. This was contrary to the pre-election consensus that BJP failing to secure a majority on its own may result in sharp decline in market.

·         The total market capitalization of NSE is higher by ~21%; more than gains in the benchmark indices – implying that stronger gains have occurred in the section of the market beyond indices.

·         The number sector outperforming the benchmark indices far outnumbers the sector underperforming. The rally was led by Realty, PSUs (mostly power, defense, and railway), Auto, infra and energy. The Capital Goods and Heavy Engineering sector have been the flavor for the period. Particularly, the businesses catering to sectors like defense, railways, and road construction did extremely well. Banks, IT Services and FMCG were notable underperformers.

·         Ship builders were the notable outperformers amongst the individual stocks. No conspicuous sectoral trend was seen for the losers.

·         Institutional flows to the secondary equity markets were positive for five out of the six months. 1H2024 witnessed a total flow of ~INR3559bn, despite FPIs outflows of Rs320bn. The correlation of institutional flows with Nifty returns remained poor (~48%).

·         The rates, currency and yields were stable in 1H2024. Policy rates were unchanged; while money market rates were marginally higher by 15bps. Deposit rates did not see much change while lending rates were higher by 10-15bps.

·         The overall Indian yield curve shifted lower and flattened completely, as the RBI maintained the status quo on policy stance.

·         The economic growth surprised on the higher side with the Indian economy recording a growth of 8.2% for FY24, beating all forecasts materially. Fiscal balance also improved with FY24RE fiscal deficit coming at 5.8% and FY25BE of fiscal deficit at 5.1%.

·         CPI inflation has inched closer to the lower bound of the RBI’s tolerance band of 4%-6% with May’24 CPI inflation number coming at 4.75%.

• Corporate performance has shown resilience in recent quarters, with sales growth recovering, margins improving and RoE rising. Banks reported consistent improvement in the asset quality and profitability.

Famous Spanish-American philosopher George Santayana famously said, “Those who do not remember the past are condemned to repeat it”. One of his less famous saying however was, “And those who do study the past are just as likely to make the same stupid mistake as those who do not”. The latter thought applies to the stock market participants more than the first;

Even though the standard guidance to the market participants is that historical performance is no guarantee to the future performance; most of the analysis and behavior is usually based on extrapolation of the past trends.

Analyzing the present consensus view of the analysts, strategists, investment managers and traders about the likely performance of Indian equities in short term (mostly next twelve months), I find that there is an unusually overwhelming consensus on the following trends:

(a)   The small and midcap stocks may do significantly better than their large cap peers largely due to sharper earnings upgrade.

(b)   Cyclicals businesses (commodities, auto, industrials and financials etc.) may do better than the secular businesses (FMCG, Pharma, Technology etc.) as the economic recovery gathers steam.

(c)    Growth stocks (businesses which have direct correlation with the economic growth like cement, steel, capital goods, oil & gas, financials, transport etc.) shall do better than the value stocks (stocks mainly bought for dividend yield, wealth preservation and secular growth, e.g., large FMCG, MNC Pharma, etc.) on relative cheap valuation.

However, a deeper peep into their analysis, gives an impression that most of them are relying heavily on the past underperformance of value, cyclical, mid and small cap etc.

In past 3 years (2018, 2019, 2020) The benchmark Nifty has gained ~34%. Only IT, financial services and services sectors have done better than the benchmark Nifty over this period. PSU Bank (-52%); Media (-52%); Auto (-23%) and Metals (-23%) have been major laggards. Small cap (-22%) and Midcap (-1%) have also lagged significantly.

This underperformance might to be the key driving force behind the present consensus view. I have absolutely no view on the correctness or otherwise of the consensus view, as it has no influence on my personal investment strategy. Nonetheless, I would like to share the following observations with the readers:

·         The small and midcap basket usually includes the following five categories of stocks:

(i)    Companies which are relatively new in the business. These companies may be growing fast and have the potential to become large; or they may not have potential to grow materially.

(ii)   Companies which were much larger in past but lost the advantage or made strategic mistakes on leverage, expansion, products etc.

(iii)  Companies which are older, stronger but their businesses are not scalable.

(iv)   Companies which have no meaningful business, but are listed on stock exchange for a variety of reasons.

(v)    Companies which have highly cyclical business. These companies do very well when their business cycle is good, but usually lose the entire gains in down cycles.

·         New companies with high growth potential and strong older companies with sustainable high dividend yields are the categories that create tremendous wealth for the shareholders.

·         Highly Cyclical businesses give massive returns to the investors who understand the business cycle and are able to buy the stocks at cusp of the upcycle and sell before the party ends.

·         Rest all categories usually inflict losses on investors; which in many cases result in erosion of entire capital invested.

·         Another noteworthy observation is that many small and midcap companies that appear to have given stupendous return in one market cycle, just disappear from market clandestinely. All hopes of recovering the losses made from investing in such companies, in future market cycles, are usually belied.

From the above observations, it could be deduced that to make meaningful money from small and midcap companies, one has to either have strong knowledge of the business cycles or have materially higher risk taking ability.

Smaller investors like me therefore should resist the allurement of quick gains. If they must, they should prefer to invest in a small and midcap fund managed by the professional fund managers, who have good knowledge of the business cycles and are usually emotionally unattached with any particular stock.