Wait for a correction
Long-term variables are against a market keen on scaling new highs.
Provisional March WPI data suggests wholesale inflation is up 9 per cent year-on-year. This is about 100 basis points above RBI projections. An analysis of WPI numbers suggests it is very likely an under-estimate; WPI may be well above 10 per cent.
In the past 12 months, provisional WPI numbers have been revised upwards, an average of 0.6 per cent per month. Right now, official data claims that fuel costs (crude and coal) have been unchanged for the past three months. In reality, both are up 15-20 per cent. So, there will be a jump in WPI when that's factored in.
There is a good chance that RBI will hike policy rates on Tuesday. But, that may not have much positive effect on the current inflationary spiral, given root causes. Apart from rising energy costs, food inflation is the major problem area. There is no band-aid fix. Given India's energy-deficit scenario, big hikes are likely after the current set of assembly elections. Food prices will reduce if there's a decent monsoon. Otherwise, in the long-term, more food production, better distribution and delivery, better storage infrastructure and so on, is required to control food prices. None of these can be implemented in a hurry.
Scenarios that combine higher interest rates, higher fuel costs and generally high inflation will always hit growth. At the same time, global growth projections are being pared down. So, exports may not maintain the breakneck growth trend of the last year.
The Q4 2010-11, and full-year results, and advisories are not very exciting. Demand, especially consumer demand, remains good and toplines have expanded. But margin pressure is evident – profits have dropped, interest costs have risen and it's difficult for corporates to pass on rising input costs.
The market has ignored the bad news. The Nifty has been range-trading, between 5750 and 5950 for two months. This cannot last. As and when the penny drops, panic selling may force prices down dramatically. There is no apparent factor that could cause widespread earnings surprises. You’ll certainly know if fuel and food costs reduce. But these would have a lagged effect.
By now, regular readers must be tired of my bearish prognosis, especially after the market bounced from its 2011 lows of Nifty 5177 to over 5900. I would be very pleased to be proved wrong by a market that powers to new highs in what remains of this calendar year. But I don’t see it happening - the long-term variables are against it.
Current valuations seem very optimistic. The Nifty is at a trailing PE of 21.8 with a PB of 3.7 and a dividend yield of one per cent. These are historically dangerous levels. They are difficult to justify by any normal investing logic.
Of course, there is always a subjective element to projections. Ask yourself the following questions. Do you think earnings growth will exceed 22 per cent in 2011-12? Are interest rates likely to fall to an average of 5 per cent or lower in 2011-12? Most analysts would answer “no” to both questions. If your answer is “no” to either, you should not be increasing equity exposure at 22 PE.
Markets can stay out of sync with fundamentals for long periods, But eventually they correct. It is also unhealthy for a long-term investor to bank on inflated valuations persisting indefinitely. My instinctive response to any further rallies would be to suggest lightening up on equity holdings by selling at higher levels. But there aren’t too many alternative avenues and a lot of long-term investors are uncomfortable selling, whatever the situation.
Among alternatives, commodities such as industrial metals, sugar, fuels and so on could provide some cover in a bear-market because some of these are non-correlated to equity market movements. Precious metals have soared to record levels and there is significant risk in buying gold or silver. Real estate is under stress with two years worth of inventories in NCR and Mumbai. There could be a collapse if the stock market falls and interest rates rise.
If you are prepared to short selectively, you may make a lot of money, as and when the market breaks. If you aren’t prepared to short, perhaps you should park spare cash in short-term deposits until such time as there’s a cooling off. Short-term deposits lose less value in a rising rate regime and at least, capital is preserved.
This is not an imaginative or ambitious way to handle your investments but it is common-sense. Preserve your ammunition and wait for a correction. Average down when it comes.