IIP data does not justify rise in equities

Either the market will correct down in the next few months or IIP must zoom up. The divergence cannot go on forever

The relationship between the IIP and the stockmarket is positive, but not a perfect fit. The market generally leads in terms of direction and the IIP follows. This is because investors anticipate changes in activity and bid prices up or down accordingly.

The lead can be a matter of weeks or it can run into several months. The IIP is a lagged indicator which usually confirms market direction. But when there has been a long period of divergence in the direction, one starts to wonder if the market has jumped the gun or made an error in consensus judgement.

This is one of those times. The market has been up since September 2012. The IIP has been down or moving sideways until December 2012. Did industrial activity pick up strongly in January 2013? If not, stockmarket prices are running in the wrong direction. One can keep hoping for an uptick in the IIP, but the longer the divergence lasts, the more the chances of prices correcting down.

There are two apparently conflicting data that could be cited in making guesses as to trends in industrial activity in Q4, 2012-13. One is that the HSBC Purchasing Managers Index (PMI) shows expansion in both January and February. The expansion is slow, but positive across both consumer and industrial segments. Given what we know of PMI construction and history, this is reasonably reliable.

The other data comes out of the auto industry. This is undeniably negative. Unit sales have fallen across the sector, costs have risen, and inventories have gone up. Maruti, Tata Motors and General Motors have all cut back production. Anecdotally, Non-banking Finance Companies in the auto finance space also confirm that sentiment is weak.

Now auto industry numbers are very reliable at the basic level of unit sales and prices at least. The industry association, SIAM, never has to revise its unit despatch numbers.

Also, auto industry data is very strongly correlated to industrial activity. So much so that one would trust it more than either the PMI or the IIP. When there have been conflicts between the auto industry numbers and the IIP, the IIP has usually been wrong and subsequently revised in the direction indicated by the auto numbers.

The strong correlation is not surprising. The auto industry sources materials and components across almost the entire industrial value chain. The raw material needs range from metals, rubbers and plastics to high-end glass and electronics components. There is a great deal of value-addition involved of course.

There is a strong connection between the auto industry's fortunes and consumer sentiment, of course. There is also a strong connect between the financial industry as well - both in terms of industrial financing and working capital needs, as well as, retail financing. Finally, the industry, directly and indirectly, employs millions including downstream in media and advertising.

Net-net it is extremely rare to find a period when the auto industry is in the doldrums and industrial activity is booming. Based on the PMI and auto industry data, the best guess would be that the IIP continued to stagnate through Q4.

The implications are interesting. In the narrowest sense, one would expect auto shares to lose ground as the market discounts the situation. More broadly, there could be a moment when the divergence between share prices and IIP trends becomes unsustainable and the market starts to correct down.

Given the length of time the divergence has lasted, any such snapback could be quite severe and it might last for a long time. It may not happen, of course, but if it does, there would be lucrative short positions available.

The principle of reflexivity suggests that any correction would probably take prices down to undervalued levels and that the correction would last for a period that could extend to months. The Nifty would be hit and industrials would be hit harder if the sentiment reversed.

The timing of any such correction would be dictated by the release of IIP numbers. This month or next month,or the month after, it could happen anytime. Every month when the IIP is due, traders should keep a lookout for the possibility. Either the market will correct down in the next few months. Or the IIP must zoom up. The divergence cannot go on forever.