Vijay Kumar Gaba

Fear, paranoia and resilience prevails in 1HFY22

The financial year FY22 started with the country reeling under the impact of an intense second wave of Covid-19 pandemic. The images of citizens struggling for life saving drugs and Oxygen, overcrowded cremation grounds and corpses of the victims of pandemic floating in the Ganges were imprinted on peoples’ consciousness. For once, disease, death, and desperation dominated the popular narrative.

The life seemed still with everyone becoming fearful and paranoid. It felt that spirituality and austerity would dominate the behavior of common man for many months to come. The government went into overdrive to build health infrastructure, provide assistance to helpless citizens and planned, what would eventually become, the biggest public vaccination drive ever in history of mankind. The austerity and fiscal discipline did not appear to be anywhere in the list of top priorities.

The macro economic data for 1QFY22 however presented a slightly different picture. Private consumption was the largest contributor to the growth and government had refrained from spending much.

The 1QFY22 growth came in better than most had anticipated as the sporadic lockdowns did not affect the economic activity. The recovery in 2QFY22 appears to be much better than estimates, with many indicators reaching pre pandemic levels. The growth estimates for FY22 have been accordingly revised upwards by most agencies.

…did not impact financial markets

The financial markets also did not reflect the sentiments peddled in the popular narrative. Despite, the government incentives to promote local manufacturing; acceleration in award of contracts for large infrastructure projects; the government support and incentives for MSME credit; significant expansion in digital banking ecosystem; revival in real estate market, etc. the credit demand growth is persisting at multi decade low levels.

The stock market has witnessed heightened activity, with benchmark indices gaining close to 20% in 1HFY22 on the back of much higher participation from the household investors. Mid and small cap stocks dominated the activity, indicating the strong dominance of the sentiment of greed over the sentiment of fear.

The market rally has been rather intriguing, given that environment for equities has not been very supportive from conventional wisdom viewpoint.

The following factors, which have bothered the equity markets historically, have been conspicuous by their exalted presence.

·         The energy prices (Achilles heel of the Indian economy) have climbed sharply higher. The second round impact of the energy inflation have also become visible in higher costs of production and freight.

·         Food inflation has persisted at elevated levels. In fact, headline inflation has persisted above the RBI comfort zone for many months, terminating any chance of further monetary easing by RBI. The debate now circles around the tightening schedule of RBI.

·         The vulnerabilities of the Chinese financial system have been exposed with one of the largest real estate developer defaulting on its debt obligations.

·         The central bankers of developed countries gave clear signals that the monetary easing has peaked and their next step would most likely be the monetary tightening.

·         RBI has shown tolerance for higher yields and slightly weaker INR.

·         Institutional investors have remained on the fringes for most part of the 1HFY22.

·         The cold war like condition between US and China has intensified further. Polarization of global trade majors is also increasing

·         Geopolitical situation at northern borders remains alarming, with no resolution in sight for Sino-Indian standoff at LAC and increasing influence of China and Pakistan in Afghanistan.

·         The strong leader of Germany lost elections to the left alliance, reinforcing the trend of the left leaning socialists gaining power in most of the large countries, the environment for free trade and globalization continues to worsen.

·         The weather has been extremely erratic world over. Unusual weather pattern were seen across continents. Unusual snow fall and drought in Latin America; Drought, extreme heat and wild fires in North America; floods in Europe, China and Indian sub-continent caused extensive damage to crops and supply chain disruptions. The prices of industrial raw materials and food increased materially world over.

·         The corporate earnings have been stronger than the estimates in 1QFY22, but the valuations in many pockets are seen prohibitively high. The valuations in commodity sectors like metals and chemicals etc. seem to discounting the current inflationary trends to the eternity.

Money in pocket may not reconcile with profits shown in SM timelines

Regardless of the presence of the supposedly adverse factors, the equity markets have remained quite resilient so far.

However, in past couple of weeks the volatility in markets has increased significantly. While various commentators and observers have attributed the rise in volatility to one or more of the above listed factors; it is pertinent to note that these factors have been present, and widely acknowledged for past many months. It would therefore not be justifiable to attribute the market volatility and jitteriness to these factors alone.

The anecdotal evidence indicates that in view of the above listed factors, the participation in equity markets in past six months has been rather tentative and lacking in strong conviction.

Most investors appear to be actively trading, frequently booking small gains/losses. Thus, even though the benchmark indices have shown strong gains in 1HFY22, not many personal portfolios may be showing the matching gains.

Now, as the market commentary turns to “cautious optimism”, “fairly priced”, “Long term Story in tact” from “abundant opportunities”, “recovery trade”, “TINA for India” etc., the unconvinced investors/traders lacking in conviction are turning even more nervous.

Of course greed is still the dominating factor and not many market participants are taking money off the table; they are even quicker in booking profit and losses.

Sector shopping in search of quick gains is also gaining higher momentum leading to faster sector rotations, giving an illusion of abundant trading opportunities. Obviously, the money in pocket is not reconciling with the money being made on social media timelines.

Money made on Twitter wall is exponentially higher than what broker’s statement is depicting and that is making the investors/traders both nervous and greedier for now. So expect, the current state of volatility and low returns to continue for few more months at least.

Economy fast recovering to pre pandemic levels

As per the consensus estimates, Indian economy shall recover to pre pandemic level latest by the middle of FY23; in what is popularly called a “V” shape recovery.

The growth thereafter is expected to be more moderate. The normalized long term growth trajectory may however not reach 6%+ level (seen in pre pandemic period) till FY27 at least.

Corporate earnings - 2QFY22e growth to be moderate as base effect withers

Nifty 4QFY21 and 1QFY22 EPS growth was the strongest in more than two decades. Poor base effect and strong pent up demand were the primary causes attributed to such sterling corporate performance.

However, these factors are seen tapering from 2QFY22 onwards, and the cost pressures are rising. We may see revenue growth as well as margins moderating this quarter.

…though the long term earnings trajectory earning to remains robust

Regardless of the moderate 2QFY22 earnings growth, the long term earnings growth (Rolling 5yr CAGR) trajectory is expected to remain strong for FY23 and later years.

Markets – Greed dominates the Fear

During 1HFY22 the market performance was dominated by the cyclical sectors like Real Estate, Metals, Energy and Infra. IT Services was the only non-cyclical sector that continued with its good performance from 2HFY21. Financials and Auto were the major underperformers.

Given their underperformance for much of the past 3-4years, sectors like Realty and Metals were significantly under-owned, it is therefore likely that most investment portfolios might have underperformed the benchmark indices.

 

FII remained net seller while DII were small net buyers in 1HFY22

During 1HFY22 over Rs59716cr were raised through 26 IPOs. This compares with Rs54576cr raised through 33 IPOs in the entire FY21. However, an analysis by the brokerage firm MOFSL highlighted that almost 52 per cent of IPO investors sold shares on the listing day. This clearly indicates towards lack of conviction amongst investors, including institutional investors, in the new businesses. Most IPO investors appear taking this as a trading opportunity to make some additional money from the funds lying in the savings account earning a pittance.

India outperformed the peers by wide margin

During 1HFY22 the Indian equities outperformed the major global market by wide margins. Nifty gained close to 20%, whereas the second best Index S&P500 of USA gained 10%. Amongst peers Brazil was the worst performing market with a loss of 7%.

Market outlook and strategy

As of this morning, there is great deal of uncertainty as to the shape of the global order that would emerge in next couple of years. It is highly unlikely that we would get much clarity over next 6-12months. To the contrary, it is more likely that the conditions become even more uncertain and unclear.

Insofar as India is concerned, I continue to feel that 2HFY22 may just be a continuation of 1HFY22, with some added complexities and challenges. The country may continue to witness protests and unrest. The consolidation of businesses may continue to progress, with most small and medium sized businesses facing existential challenge. Disintermediation and digitization may also continue to gather more pace.

The normal curve for the economy may continue to shift slightly lower, as we recover from the shock of pandemic. A large part of the population may continue to struggle with stagflationary conditions, with nil to negative change in real wages and consistent rise in cost of living. Geopolitical rhetoric may also remain at elevated levels.

Market Outlook – 2HFY22

The outlook for markets in the near term is mostly negative.

Macroeconomic environment - Neutral

Global markets and flows - Negative

Technical positioning – Negative

Corporate earnings and valuations - Negative

Return profile and prospects for alternative assets like gold, real estate, fixed income etc. - Negative

Greed and fear equilibrium - Negative

Perception about the policy environment - Positive

Outlook for Indian markets

In view of the positioning of the above seven key factors, my outlook for the Indian equity market in 2HFY22 is as follows:

(a)   Nifty 50 may form a short term peak in next couple of months. The process of forming the top has already started. In case the market follows the trajectory of 2HFY08, we may see the top around 18700-18900 level, followed by a sharp correction. However, if Nifty follows the pattern of 1HFY07, we may see top around 18200-18300 followed by a sharp 20% correction and a sustained rally thereafter.

(b)   The outlook is positive for IT, Insurance, large Realty, healthcare, agri input, and consumer staples, negative for commodities, and neutral for other sectors.

(c)    Benchmark bond yields may average below 6.5% for 2HFY22. INR may average close to 74 in 2HFY22.

(f)    Residential real estate prices may show a divergent trend in various geographies, but may generally remain strong. Commercial and retail real estate may also continue to see recovery.

Key risks to be monitored for the market in 2HFY22

1.    Relapse of pandemic leading to a fresh round of mobility restrictions. (Less likely)

2.    Significant worsening of Sino-US trade relations.

3.    Material tightening in trade, technology, and/or climate regulations in India and globally.

4.    Hike in effective taxation rate to augment revenue.

5.    Material escalation on northern borders.

6.    Prolonged civil unrest.

7.    Stagflation engulfing the entire economy, as inflation stays elevated and growth fails to meet the expectations.

8.    Premature monetary tightening.

Investment - Strategy

Asset allocation

2HFY22 may be a difficult period for investors, in terms of high volatility, poor expected returns from diversified portfolios and poor return from long bond portfolios as yield firm up. In view of this, I shall continue to maintain higher flexibility of my portfolio; keeping 30% of my portfolio as floating, while maintaining a broader UW stance of equity and debt.

Large floating allocation implies that I shall continue to trade actively in equity. 30% of portfolio would be used for active trading in equities and debt instruments.

My target return for overall financial asset portfolio for 2021 continues to be ~7.5%.

Equity Strategy

I would continue to focus on a mix of large and midcap stocks. The core criteria will be old economy cyclicals which are cheaper from historical and contemporary perspective, have decent market share, are changing business model to suit the new conditions, and would benefit from economic recovery.

I would target 6-7% annualized price appreciation from my equity portfolio.

Miscellaneous

I have assumed a relatively stable INR (Average around INR74/USD) and slightly higher short term rates in investment decisions. Any change in these assumptions may lead to change in strategy midway.

I would have preferred to invest in Bitcoin, but I am not considering it in my investment strategy due to inconvenience and unease of investing.

Factor that may require urgent change in strategy

·         Material rise in inflation

·         Material change in lending rates

 Presently, a large part of the market analysis and commentary is focused on the stock rally from the low prices recorded in March 2020. The popular narrative is that investors have made extraordinary return on their equity portfolios, in what was a once in a decade opportunity.

In my view, this narrative suffers from a serious lacuna. This narrative assumes that—

(a)   Investment is a discreet process and not a continuous one. Investors make investments only on occurrence of some event and exit as soon as the impact of that event dissipates.

(b)   The economic behavior of a majority of investors is rational. They are able to control the emotions of greed and fear very well.

(c)    Most of the investors have infinite pool of investible surplus, and they are able to invest material amount of money at their will.

Unfortunately, none of these is even half true.

Investment is a continuous process. Most of the investors stay fully invested in markets at most of the times. Usually, they reduce their exposure to risk assets like equity when down trend is fully established. So in March 2020, investors were raising cash not investing fresh money.

The economic behavior of a majority of investors is not rational. They are materially influenced by the forces of greed and fear. In summer of 2020, fear was the overwhelming sentiment. Expecting investors to increase risk in their portfolio at that time is akin to expecting a patient lying in ICU to worry about the sale in neighborhood grocery store.

An overwhelming majority of investors have a finite pool of investible surplus. A large part of this surplus remains invested at most of the times. The crash in March-April 2020 resulted in erosion in the market value of these investments. For the investors who could stay invested in the fall, the erosion has been mitigated by the subsequent rise in prices. The investors whose risk tolerance was breached by the fall would have exited their positions and therefore there losses would have become permanent in nature. Very few investors would have made material incremental investments close to the market bottom last year. Only these investors have some reason to celebrate. For most others, it is business as usual.

Statistically, if we eliminate the fall in March and April of 2020 and subsequent V shaped recovery and assume a market in ad continuum, Nifty is up about 26% from the pre Covid high recorded in January 2020. The past two year (June 2019 to June 2021) have yielded a near normal return of ~13.5% CAGR.

Small cap (55%) and Midcap (52%) have given better return than Nifty (26%) since pre Covid high of January 2020. However, if we consider the return of mid and small cap for past two years, there is hardly much to distinguish.

Most notably, PSU Banks and Media sectors are yet to reach their pre Covid highs. Banks, Realty, FMCG and Services are all underperforming Nifty if we consider data from pre Covid (January 2020) period. Metals, IT and Pharma are the only sector that have outperformed Nifty meaningfully in Past 16 months. These sector put together account for less than 30% weight in nifty.

The point I am trying to raise is that the investors must cut the noise out and focus on their investment strategy, which must be in full consonance with their and aptitude and risk appetite. Listening to the popular narrative and getting overwhelmed with the feeling of missing out (FOMO) will only lead them to make mistake that may cost dearly.

 

 

I shared my investment strategy with readers in December 2020. I expected 2021 to be one of the most difficult years for investors in terms of high volatility, poor expected returns from diversified portfolios and continued low return expectations from cash and debt. After 3months into the year, I am even more confident about my view.

I continue to believe that to generate normal return on the financial asset portfolio one would need to maintain a certain degree of flexibility in portfolio. A part of the portfolio may be dedicated to active trading, at least in 1HFY22. I am therefore not changing my investment strategy for next 6months at least.

I may share my current investment strategy as follows:

Asset allocation

I shall continue to maintain high flexibility in my portfolio, by keeping 30% of my portfolio as floating, while maintaining an UW stance of equity and debt.

Large floating allocation implies that I shall be trading actively in equity.

(a)   The fixed equity allocation would be 40% against 60% standard.

(b)   The fixed debt investment would be 20% against 30% standard.

(c)    I would park 10% in cash/money market funds.

(d)   30% of portfolio would be used for active trading in equities and debt instruments.

My target return for overall financial asset portfolio for FY22 would be ~7 to 7.5%.

Equity investment strategy

I would continue to focus on a mix of large and mid cap stocks. The criteria for large cap stocks would be growth in earnings; while for midcaps it will be mix of solvency & profitability ratios and operating leverage.

(a)   Target 6% price appreciation from my equity portfolio;

(b)   I shall be overweight on IT, Insurance, Healthcare, Agri input and large Realty stocks. I shall maintain my underweight stance on lenders for at least 1HFY22.

(c)    For trading I will focus on large cap liquid stocks.

Miscellaneous

I have assumed a relatively stable INR (Average around INR74/USD) and slightly higher short term rates in investment decisions. Any change in these assumptions may lead to change in strategy midway.

I would have preferred to invest in Bitcoin, but I am not considering it in my investment strategy due to inconvenience and unease of investing.

Factor that may require urgent change in strategy

·       Material rise in inflation

·       Material change in lending rates

Also read

FY21 in retrospect

 I remind myself of this narration almost every market cycle. I think, it is the time to reiterate once again.

Have you ever been to vegetable market after 9:30PM? The market at 9:30PM is very different from the market at 5:30PM.

At 5:30PM, the market is less crowded. The produce being sold is good and fresh. The customer has larger variety to choose from. The customer is also at a liberty to choose the best from the available stock. The vendors are patient and polite, and willing to negotiate the prices. As the day progresses, the crowd increases. The best of the stuff is already sold. Prices begin to come down slowly. The vendors now become little impatient and less polite and mostly in "take it or leave it" mode.

By 9:30PM, most of the stuff is already sold, and only inferior quality residue is left. The vendors are in a hurry to wind up the shops and go back home. The prices are slashed. There is big discount on buying large quantities. Vendors are aggressive and very persuasive. Customers now are mostly bargain hunters, usually the small & mid-sized restaurant, caterers and food stall owners. They buy the residue at bargain price, cook it using enticing spices and oils, and serve it to the people who prefer to eat out instead of cooking themselves, charging much higher prices.

The cycle is repeated every day, without fail, without much change. No one tries to break the cycle; implying, all participants are mostly satisfied.

A very similar cycle is repeated in the stock markets.

In early cycle, good companies are under-owned and available at reasonable prices. Market is less volatile. No one is in a hurry. Smart investors go out shopping and accumulate all the good stuff.

Mid cycle, with all top class stuff already cornered by smart investors, traders and investors compete with each other to buy the average stuff at non-negotiable prices. Tempers and volatility run high.

End cycle, the smartest operators go for bargain hunting; strike deals with the vendors (mostly promoters and large owners) to buy the sub-standard stuff at bargain prices. Build a mouth-watering spicy story around it. Package it in attractive colours and sell it to the late comers and lethargic, at fancy prices.

The cycle is repeated every day, without fail, without much change. No one tries to break the cycle; implying, all participants are mostly satisfied.

If my message box is reflecting the market trend near correctly, we are in the end cycle phase of the current market cycle. I daily get very persuasively written research reports and messages projecting great returns from stocks which no one would have touched six months ago, even at one third of the present price.

The stories are so persuasive and the packaging so attractive that I am tempted to feel "it's different this time." But in my heart I know for sure, it is not!

In past one month, the set of businesses commonly referred to as “cyclical” in stock market jargon has outperformed remarkably. This one month outperformance has resulted in this set of stocks outperforming the benchmark Nifty on past 12 month performance basis also. Though, on three performance basis these stocks continue to lag substantially.

If I go by the media reports and the messages and report in my inbox, there is still “huge” value left to be realized in these set of stocks. The arguments are varied and quite persuasive.

·         A former CIO of a fund recently tweeted that “Deeply negative rates with excess liquidity getting cleared at zero rates is like cocaine to asset markets. We are in midst of a blow off top rally and if RBI does not mop this liquidity then stock prices in India could rise beyond imagination.

·         Another prominent fund manager, reputed for his stock picking skills, argues that so far the liquidity has gone into financial assets. From here on liquidity may move to real economy and fuel demand for infrastructure building and capacity creation. Components of cost like power, labor and interest rates are favorable for Indian businesses hence profitability should improve. There is strong case for investing in cyclicals which will benefit from capacity building in infrastructure and manufacturing.

·         The global brokerage firm Goldman Sachs (GS), in a recent report, highlighted that global Copper prices are now at highest level in past seven years. GS forecasts that “the world’s most important industrial metal was in the first leg of a bull market that could carry prices to record highs.” The report further emphasizes that-

“Against a backdrop of low inventories and net zero carbon pledges from countries including China, Japan and South Korea, Mr Snowdon believes significantly higher copper prices will be needed to incentivise new supply and balance the market.

We believe it highly probable that by the second half of 2022, copper will test the existing record highs set in 2011 [$10,162],” he said. “Higher prices should ultimately help defer peak supply and ease market tightness, but this first requires a sustained rally through 2021-22.”

·         A report by Motilal Oswal Securities highlights that Indian steel spreads have risen ~25% in 3QFY21 and are at a three-year high. Brokerage expects the spreads to stay strong on the back of a domestic demand recovery and higher regional prices.

It is further noted that Despite domestic iron ore prices rising to a five-year high, spot steel spreads are at a multi-year high due to higher steel prices and subdued coking coal prices. While iron ore prices from NMDC have increased by 30% YTD in FY21, imported coking coal prices have declined by ~35% YTD, keeping total raw material cost in check. As a result, domestic steel spreads are strong at INR33,000/t for flats (HRC) and INR30,000/t for longs (rebar).

·         Nirmal Bang Institutional Equities notes that Automobile sales continued its growth momentum in November’20 amid rise in preference for personal mobility on the back of good festive demand, upcoming wedding season, soft base due to overlapping of Diwali in November this year and continued positive sentiments in rural & semi urban markets. Barring 3Ws, all the segments reported YoY volume growth.

·         Emkay Global highlighted in a recent report that Chemical prices are firming up. The report mentions that In Nov’20, prices for key products such as Phenol, Benzene, Acrylonitrile, Butadiene, Toluene and Styrene jumped over 20% MoM in international markets. Rising container freight costs (~2x) on dedicated Asian routes due to a capacity crunch have pushed prices higher for certain chemicals. Freight costs within Asia are also likely to see an uptick in Dec’20 as carriers are prioritizing long-haul routes over shorter ones as a result of better economics. PVC prices have increased 10% MoM and are likely to swell further next month.

On the other side of the spectrum are people like Peter Chiappinelli of GMO, who are convinced that this liquidity fueled rally is about to end anytime now. In the latest GMO Asset Allocation letter, Peter emphatically advised his clients as follows:

“Currently, we are advising all our clients to invest as differently as they can from the conventional 60% stock/40% bond mix, just as we were advising them in 1999. Back then, we were forecasting a decade-long negative return for U.S. large cap equities. And that is exactly what happened. Today, the warning is actually more dire. U.S. stock valuations are at ridiculous levels against a backdrop of a global pandemic and global recession, and CAPE levels are well above 2007 levels, within shouting distance of the foreboding highs reached in October 1929. But it gets worse. U.S. Treasury bonds – typically a reliable counterweight to risky equities in a market sell-off – are the most expensive they’ve been in U.S. history, and very unlikely to provide the hedge that investors have relied upon. We believe the chances of a lost decade for a traditional asset mix are dangerously high.”

My personal view is that it’s 9:30PM in the stock markets. I believe that in post pandemic era, many of the traditional businesses may even not survive. Besides, in Indian context, the present capacity utilization levels may not warrant any significant capacity addition in next couple of years at least. The so called “Atam Nirbhar” capacity building trade may mostly be limited to soft commodities (like chemicals); electronics and defense production. Unlike 2003-10 infra capacity additions, it may not trigger any life changing opportunity for many engineering and capital goods companies.

The logistic constraints and paranoid inventory building by some economies may cease in next six months as vaccine is made available to more and more people. The Central Banks, especially RBI, may look at containing liquidity in 2021, before it can actually cause an inflationary havoc. The hyperinflation which many analysts, economists and fund managers are secretly praying for since QE1 in 2009 may actually not happen at all. I am also convinced from my own research that stress in unsecured credit segment has increased materially in past few months and banks will have to bear the brunt of this. I shall therefore let this trading opportunity in financials, commodities and cyclicals passé.