Price action in financial markets is influenced by many variables. Right now, all of them seem to be bearish or, at best, neutral. In that context, the breakdown on Friday came almost as a relief. After a long period of range-trading, prices seem to be aligning with fundamentals.
The Finance Bill is due to be voted on today. That should finally offer some clarity on the General Anti-Avoidance Rule and the tax status of the Mauritius-route. If nervousness on these fronts is allayed, it may help sentiment. But the newsflow has been so very negative in the past two weeks that even reassurances on the tax situation may not reverse market direction.
Concerns about global stress have increased. Europe is looking grim with Spain and Italy on the ropes. The UK is now officially in recession. France’s election adds political uncertainty. China is going through its own opaque political issues. The US is not in full-blown recovery. Energy prices are high owing to fears of supply disruption. Tensions in West Asia and North Africa haven’t eased. (Click here for chart)
India’s macroeconomic problems were highlighted by Standard & Poor’s outlook downgrade from stable to negative. However, there are no signs of fiscal policy measures to control the fisc or the current account deficit. Instead, there’s a mess in telecom and the 12th-Plan documents are still awaited.
The monetary cards have already been played with a big 75 basis point cash reserve ratio cut and a 50 basis point repo cut. Domestic inflation remains high, if the consumer price index, or CPI, of 8.8 per cent for March is any indicator. The Reserve Bank of India (RBI) is unlikely to cut again, anytime soon.
Full-year corporate results and guidances show few signs of recovery or optimism. In many sectors, the trend remains the same that we’ve seen for the past nine months. Margins are tighter and there’s not enough volume growth to compensate. By now, enough of the big guns have declared results for the trend to be extrapolated with some confidence. Both foreign institutional investors (FIIs) and domestic institutions continued selling through the past fortnight.
The long dollar trade (a long USD/INR position) that was previously recommended still looks worth holding. If the trade gap continues to widen and FIIs continue to sell, the rupee will drop further. At some stage, RBI will probably be forced to intervene but it will do so gingerly.
The reserves equation isn’t very comfortable. The following numbers are rough estimates. India’s external obligations are around $340 billion. Subtracting gold and International Monetary Fund special drawing rights totalling about $30 billion, cash reserves are about $265 billion. FII holdings in Indian debt and equity were roughly worth $205 billion at April-end — about $11 billion of that came in between January and March. All FII holdings are in theory, hot money.
The debt market had falling yields immediately after the rate cut. But yields have hardened again and inversions exist at many spots on the yield curve. Short-tenure treasury bills are offering higher yields than the benchmark 10-year government securities, or G-Sec. Most banking and financial stocks have seen selling in the past week despite the rate cut.
The weakness in financial heavyweights is in part responsible for the stock market breakdown from its range-trading pattern. On Friday, the Nifty dropped below its own 200-Day Moving Average. This is usually a reliable signal that the long-term trend is bearish. It is not surprising. Retail investors cannot absorb selling by both domestic institutional investors (DIIs) and FIIs. Most technical indicators are negative.
Trend following technicians would expect further falls in the Nifty and in high-beta sectors like financials, capital goods, real estate, construction and automobiles. An immediate target of about Nifty 4850-4900 looks likely within the May settlement. The index could fall a lot further in the long run. A reversal and bounce could only come about in the near term, if the FII turn buyers again.
Defensive allocations to the traditional havens of fast-moving consumer goods (FMCG) and pharma are already visible. Most FMCG majors have also done well, going by Q4 results. A third sector that’s perhaps worth looking at is hospitality — it does have forex earnings. IT will also gain at some stage from a weak rupee but IT guidances have been pretty cautious.
It may be useful to assess levels at which Nifty valuations become attractive. Government debt is offering yields of 8.5 per cent to 9.5 per cent. A vanilla bank FD could fetch around 7.5 per cent. Allowing for a Nifty dividend yield of 1.5 per cent, and also for the superior tax treatment of long-term capital gains, one would say a Nifty PE of 15-16 could be fair value.
Another way of assessing fair-value is to calculate the PEG ratio of PE to (expected) earnings growth. Various analysts’ estimates of earnings growth in 2012-13 range between 13 per cent and 16 per cent for the Nifty. The long-term CAGR of Nifty earnings is 15 per cent. If fair value is held a PEG of 1, we could again say the Nifty would be fair value at a PE of less than 16.
For a technician, it’s easier to define the levels to watch now that there’s been a breakdown. On the downside, a fall till 4900 could be a target over the next 10 sessions. The classic way to play this sort of breakdown would be to take a short futures position with a trailing stop loss. On a bounce above 5280, one would write off the breakdown as a false signal. The 200-Day Moving Average is at roughly 5125. That could be a stop loss for a day trader. Shorts with a timeframe of, say, five sessions could be stopped at, say, 5175-5200.