Given the magnitude of the returns this year, it is prudent to protect them to the extent possible, says Akash Prakash
There is a general sense of unease among professional money managers towards the equity markets. We have had a huge rally across global equity markets, with Asia up almost 50 per cent for the year, and even the OECD markets up 40-50 per cent from their mid-March lows.
Investors’ biggest concern is the sustainability and pace of the economic recovery, especially in the OECD economies. The bears are convinced that while the US and European economies have stopped contracting, and will show growth in the second half of 2009, equity markets are way ahead of themselves. The concern is that the recovery will be too weak to validate the bull case. The economic recovery will be very subdued, sub-par and jobless, and in no way resemble the V-shaped outcome equity markets seem to be pricing in. Continued deleveraging and lack of income among consumers, limited ability and willingness to lend on the part of the financial system and excess capacity precluding any need for investment among corporates, are most often cited as the causes for a subdued growth trajectory. Given the uncertainties of this cycle, a double dip can also not be ruled out as governments withdraw emergency measures.
While the bears may be right about growth coming out of this recession being a disappointment, is such an economic outcome necessarily negative for equities? One can easily make the case that the best environment for equities is one of subdued growth, and not the V-shaped recovery bears fear the market is pricing in. A subdued and halting economic recovery will allow equities to remain in the sweet spot of easy liquidity, low inflation but improving economic and corporate fundamentals. This is the point in the economic cycle where policymakers are still totally focussed on stimulating growth, and inflation is not yet an immediate concern, but the beginnings of growth are visible.
On the other hand, a sharp V-shaped recovery will in all probability force the hand of central bankers and we will see a shift in policy to exit the current super-stimulative policy regime. Such a policy shift will in all likelihood have a serious negative impact on equity markets. Given the trading pattern of the last few months, markets seem hypersensitive to even discussions of policy shift on the part of the central banks.
Thus the bears may be right about the upcoming economic recovery in the US and Europe being far more anaemic than the market is thinking, but ironically such a scenario may only go to extend this cyclical bull rally.
This rally may still have some legs given that the most likely cause for a short circuit — viz a change in policy stance so as to roll back liquidity, fiscal stimulus and quantitative easing — seems to be still some distance away.
Having said this I think there is a very strong case, at least from a tactical perspective, to buy insurance to protect your portfolio from a 10-15 per cent type of correction, through either buying options or building cash levels.
We are, first of all, entering a seasonally very tough period for equities. The months of September and October have normally not been kind to equity markets, and historically one has seen many sell-offs in these months.
Secondly, the cost of protection has come down globally, with the VIX index having fallen by 67 per cent over the last nine months. Risk aversion has clearly reduced. Contrarian sentiment indicators measuring the bullishness of retail investors and fund managers also indicate much more complacency towards equity risk.
The performance of Chinese equities is also a cause for concern, given that these markets have been leading indicators for global markets over the past 18 months. At one stage last week, they were down 20 per cent. The continued decline of the Baltic dry bulk index, despite the stabilisation of the Chinese equity markets, is also a worrying divergence.
Trading volumes and breadth, at least in the US, do not give comfort on the short-term sustainability of this rally. The Bank of Israel hiked rates with the highly respected Stanley Fischer as governor. Could this mark the beginning of a reversal of the global cycle, far earlier than markets are pricing in?
The case for buying protection is even greater in the case of India. Our markets have been among the best performing large markets this year. Despite this huge run-up, protection has rarely been cheaper, as volatility skews have flattened.
What bothers me about India is that even though most professionals are nervous, they are unwilling to sell stocks or pay up for protection, as going against the markets the last five months has been a very painful and expensive proposition. Desperately chasing performance, and trying to catch up with the markets’ breathtaking run, investors are loath to give up returns by either selling too early or paying for useless protection (useless till date at least). Even the smartest proprietary traders have lost so much money trying to anticipate a market break, that they no longer have the risk appetite to go against the trend.
In the case of India, due to the weak monsoons, we are seeing cuts in growth forecasts for 2010. Along with lower growth, serious risks in the form of a surge in food prices and inflation exist. Chances are that the fiscal situation will only worsen as the government has to engage in drought relief and ramp up food subsidies. Interest rates have already started creeping up, despite enormous liquidity in the system and the next move of the RBI is to hike.
A combination of factors — cuts in GDP growth rates, rising interest rates and stress in rural India — does not equate with corporate earnings upgrades. Commodity prices have also risen in the last six months, which will offset much of the margin expansion we have seen in corporate India in the last quarter. The market is also not particularly cheap.
Supply of paper is seemingly limitless, and we have just seen one very large IPO have a disappointing listing.
Policy traction from the government is still not aggressive enough, and not enough has been accomplished, despite the setting out of clear 100-day goals by many ministries.
While we do expect a correction, any fall will be a buying opportunity, as I still believe India will be a very exciting investment destination over the coming years. There is still so much low-hanging fruit on the policy side, which can keep markets enthused and ensure strong growth.
There still exists the strong possibility that this whole cycle will ultimately end with a bubble in emerging market stocks. India will be a major beneficiary of any such rush of liquidity into the asset class.
Given the magnitude of the returns we have seen this year, I think it is more prudent to try and protect these returns to the extent possible as opposed to trying to make the last 10 per cent. One will get a chance to buy stocks cheaper, it is only a matter of time.