Thoughts 2015: The bearish angle on equities
After a rollicking 2014, investors are Wondering what 2015 has in store for them. Most analyst predict that the Bull Run is here to stay, Although I agree to this Bull Run theory but I also feel that bull runs can have very powerful corrections and we could be a witness to that very soon.
The next 3-4 months will serve as the true test for that “long term” investor and every optimistic view of equity markets will be revisited. Some of my biases come from the data thats available and the remaining comes from an intuition which is hard to pen down. I will elaborate on a few points here but by no means will this article be able to sum up all the data points and the so called intuitive instincts.
Premise for a 15-20% correction
Markets in India are rising on the back of a broad based agreement. The agreement being that Prime Minster Modi will alter the course of this country and and steer the economy in the right direction.
In my opinion bull markets don’t begin with such a consensus. I am also aware that I can’t predict a fall in the markets just based on this loose statement. So I began looking for a premise and found it from the asset allocation text book and from a note that a colleague of mine had sent me a few years back. This analysis is a simple one and that’s why it makes a lot of sense. Here it is:
The 10-year Indian government bond is quoting at 7.98%. It basically means that an instrument like the Indian government bond will yield 8% on the amount you invest. Now if you take the same amount and invest in the SENSEX you should THEORITICALLY receive 5.3%. This is called the Earnings Yield which is nothing but the inverse of the popular Price to Earnings Ratio or P/E Ratio.
Think of earnings yield as Rental Yields. Say you buy a house for Rs 2 crore and give it on rent earning Rs 30,000 per month. By the end of the year you have a rental income of =12 months*30k= Rs 360,000. So your rental yield is 360,000/2 crores =1.8%. The Price to earnings ratio of your house is 2 cr/360k = 55x! or just the inverse of 1.8%.
The P/E ratio for Sensex/Nifty is at 19x. So inverse of this number which is the Earnings Yield is 5.3% (1/19*100). As you would have noticed that a risk free Bond is giving you 8% – almost 1.5 times more returns than the SENSEX. We take this 8%/5.3% = 1.5x and we will call this ratio X. Now if you go back in time and graph this ratio X (as shown in the graph below) you will notice that this ratio moves between 0.5 x – 2x across various stages of the economy & markets.
What’s even more interesting in these graphs is that equity market top out when this ratio X reaches 1.8-2x times and bottoms out when this ratio reaches 0.8x-0.5x. This is fairly intuitive. When the ratio moves up to 1.8-2x it basically signals that a risk free bond is giving you 2 times the returns than an equity Index can give.
Alternatively when the ratio bottoms at 0.8-0.5x, it signals the opportunity that holding equity is far superior than a risk free bond. Currently the ratio stands at 1.5x so we are at the higher end of this ratio range.
In order for this ratio to come down, EITHER of the two situations have to pan out: a) Bond Yields fall from here or b) Earnings Yield rise. Markets are expecting bond yields to fall in 2015 by at least 75-100 bps. So Bond Yields could be at 6.9-7% and assuming market stays in a range, the ratio would still stand at 1.3x which is still a tad high.
I don’t think earnings will accelerate rapidly in the coming quarters either, so the only way this ratio comes down is that prices – the very P of the P/E ratio correct by atleast 10-15%. Please see chart below. Ratio X (Govt Bond Yields divided by Earnings Yield) is plotted on the secondary Axis and Nifty Index is plotted on the primary Axis.
If some of you agree to this foundation for a correction then the next question is what will trigger a sharp equity correction? This is the hard part and I’ve tried to work up a bearish story connecting everything I have read/observed in the past 1-3 years.
Reason#1: Brand Modi: The euphoria around Modi will begin to fade away as investors will frustrate over lack of “big bang reforms” and overoptimistic programs such as Make in India which targets increasing manufacturing’s share of GDP to 25% by 2022 from current 16%.
In my view this is an UNREALISTIC GOAL particularly in India given the complexities in our administrative processes and Centre-State relationships. According to one broker report, industrial sector booms in China, Korea and Thailand suggests that on an average it takes 10 years to increase the share of industrial sector output by 3-5% points. Here we are aiming for 9 pct increase in 8 years?
Reason #2: European Union issues can resurface. Europe (ex -Germany) appears to be in a bear market (as per simple Dow Theory charts). Governments could continue to push negative deposit rates but would eventually find itself in a fix. Commercial banks won’t pass on negative rates to depositors for fear of losing customers. When banks absorb the costs themselves, it squeezes the profit margin between their lending and deposit rates, and might make them even less willing to lend. A full blown quantitative program by the ECB is one possibility but only after much firefighting.
Reason#3: UK Real Estate frothing up. In July 2014, Bank of England deputy governor Sir Jon Cunliffe had told BBC that the housing market poses the “biggest risk” to the UK economy. They have surpassed 2007 peaks which also pushed the IMF to send out a warning signal that accelerating house prices and low productivity pose the greatest threat to the UK’s economic recovery. A heated housing market could cause a lot of worry for global markets and may alter the course of policy decisions by Bank of England. BOE will need to weigh the pros and cons of a premature rate hike.
Reasons # 2 and # 3 will provide an exceptional fillip to the US dollar which will have implications for all emerging markets including ours. Consensus is portraying a very accommodating RBI policy into the New Year and I feel this will fall short of people’s expectations. In light of global uncertainty and impending fed rate hikes- rbi rate cuts may not be aggressive – cause of potential disappointment. The situation could be similar to 1999 when optimism in US stood in stark contrast to gloom elsewhere. By 1999 US GDP was rising at 4%, Unemployment fell to 4% and the S&P Index was flying high. At the same time between 1997-1999 emerging markets such as Brazil and Thailand saw their currencies crash and see growth rates turn down.
Reason #4: Chinese Stock Markets vulnerable to steep declines. Shanghai stock markets has climbed 50% in 2014. Andy Xie, the former World Bank economist who was one of the 50 most influential people in global finance said that the advance in stocks in China is another bubble driven by leveraged traders. Same guy predicted the 2007 crash in China. In one of my earlier notes I had suggested that Chinese markets could move 50% and a large part of that move has already happened. I sense that the Shanghai Composite will make a dash to 3500-3800 (CMP is 3200) before correcting significantly.
Reason#5: Oil dependent economies – Russia , Canada, Nigeria and the United States will be hurt. This is straightforward. UBS AG notes U.S. company defaults may be as high 10% if the West Texas Intermediate crude slides to US$50 a barrel for a considerable period of time. Index majors such as Chevron, Exxon, BP, Royal Dutch carry significant weights in world indices. Further default risk for countries like Russia and some South American countries still weighs heavy. Russia CDS and bond yields have gone off the handle.
The intention of this note is not to scare you from equities. We as investors/traders tend to focus our energy on all things positive. It is in our DNA. My reason for writing such a bearish note was a) to simply be aware of what’s out there and b) I saw no point writing a Bullish note given the overabundance of such notes floating around.
I expect the Nifty to move to 8600-8700 in the coming weeks post which I sense we could head into a severe correction. Please note this is a 3-4 month view. Your feedback is appreciated. Please write to me at firstname.lastname@example.org