Markets: Up or down?
Call it a bounce back, a recovery, fundamentally driven or a technical reversal, whatever it is, the stock market has bounced back sharply after plummeting almost 1,000 points at the blink of the eye. There are also relieved faces on the business channels off late in light of the recovery! Here is our take on the markets, without pretending to be 'we-said-so'.
As we have maintained through the years, we do not predict or take a call on where the Sensex is heading in the next six months to one year. This, we believe, has its own limitations and we are happy to leave it to the 'experts' to make that call. Looking at the corporate sector performance in the first six months of FY06 and taking a cue from our interaction with corporates, we see the risk-reward equally poised.
By this, we mean that the valuation, which is what investors should worry about instead of the price of a stock, adequately reflect in the near-term (one to two years, depending on the sector and the company) growth in earnings whilst offering relatively attractive upside from a two to three year standpoint. By relatively we mean, as compared to fixed deposits and a few government savings schemes, the upside from investing in stocks over the next two to three years seem to be on the higher side. Fixed deposits, these days, hardly cover the rate of inflation! At the same time, this does not mean investors should not park their money in fixed deposits or government savings schemes. A judicial mix is a much-preferred option. Needless to say that it depends on one's risk-return matrix. If one is more risk taking, the weightage of equities can be on the higher side.
Coming back to valuations, here are some examples. Why should engineering companies trade at price to earnings multiple of around 18 to 20 times based on the estimated FY07 earnings when the best of software companies are trading at a discount for a similar time horizon? While we agree that the fundamentals of the Indian economy are strong, why do bigger and smaller banks, irrespective of the scale of operations, trade at similar valuations?
One may justify by saying that the smaller companies are likely to grow faster. But is anyone concerned about the downside risk to the expectations in earnings growth? The second quarter performance and the correction in price of few stocks clearly reflect the mismatch between expectations and potential (we are not referring to only Ranbaxy here). Talking about Ranbaxy and even Geometric Software, just because one-quarter performance was poor and the company failed on one approval, does it mean it is the end of it? Four years before, when Infosys lowered its earnings growth target, everyone in the street dumped the stock. Now a days, people view Infosys as a 'defensive' stock! We are not talking in hindsight here. We have recommended these stocks, when they have been 'out of flavour'.
Management of companies typically have a business plan, which they like to execute over the next five to ten years, depending on the capability at the top. Investors therefore, are better off to align their expectations with the management's vision. Otherwise, there is likely to be disappointment.
Where to from here? We suggest investors (once again!) to lower their return expectations and have a judicial mix of equities and other asset classes. Even in equities, have a prudent mix of large-caps and mid-caps, even if some fund manager suggest investors to have higher weightage towards mid-caps.
Rising interests - both at the money market (Fed) of long bonds - is not good for the stock exchanges. Period. And here forget at first about valuations (no matter how you measure them) - they are not that important. We are confronted and (it is not over by now) with rising interest. If the money supply "narrows", the shares suffer. One should expect some difficulties on the stock exchanges for the coming time.
Now, the situation, as previously said, is somewhat more relaxed due to low interest rates. That why the US markets keep stable. Nevertheless, the increasing yields "endanger" the stocks. Don't get me wrong - no crash, no bear market. Possibly even easily improving Wall Street, but "with emergency brake on".
The danger of inflation is to a large extent well-known and well-considered. The prices reacted accordingly in October (downward). Nevertheless a decrease in liquidity can be hardly "discounted" - when it comes, it inevitably affects the market. However we speak of a tightening of liquidity from a high level. Therefore the monetary situation is not yet causing concern.
Secondly, the danger of inflation mainly comes from the energy prices (and in second place by the strong real estate market). Each easing here could let the Fed to pause with the interest rates increases. In my eyes this would move the fairly attractive valuation of the stocks relative to fixed income immediately into the focus of the investors.
If the inflation , i.e. the energy prices, should persistently stay high, the Fed will the go on for so long until the economy clearly cools down (if necessarily, naturally, until recession).
The question is, where is the threshold at that the commodity prices (energy) plus property market the USA eases (stops): an easy or strong cooling or only with recession?
Since I assume that by the increasing interests the American economy will just a little bit "weaken", i.e. show somewhat lower pace of growth, the real estate market will stop ("but not burst") and the energy prices will more promptly react (downward), the stocks are a Buy (or a Hold respectively). I expect possible corrections but not too sharp.
Posted by
saviano |
7:50 PM