The recent weeks are seeing the trend turn in several areas. Investment flows are looking very different with the persistent selling of FIIs in Indian equity.
News flows are also not looking great in February. For instance, first we had the budget levied long term capital gains tax on equities. Then, SEBI banned overseas stock exchanges like the SGX from using Indian indices to create products. Now, the PNB scam and the risk of its contagion effect on PSBs. Finally, the rising prospect of early elections in end 2018.
But these are more in the nature of reasons to explain market direction. The real reasons seems to be far more serious and structural. The uncertainty of global commodity prices, risks to fiscal discipline being maintained, upward pressure on inflation, possibility of rising interest rates, and the alarming prospect of a return to coalition governance are clearly worrying global investors. The higher volatility in global markets is definitely not helping matters either.
After enjoying decent macro tailwinds for a very extended period of time, we seem to be heading into a phase of macro headwinds. Such a phase inevitably leads to a lot of top down basket selling of the indices by global investors. Events of the past few weeks seem to reaffirm the onset of this selling trend.
Will this trend grow into a flood or will it reverse quickly? We will know in the coming weeks.
“The safest and most potentially profitable thing is to buy something when no one likes it.”– Howard Marks
So, when the budget threw capital gains tax at our stock markets, we kind of knew that it was not going to be the end of bad news. The U.S markets quickly went into a steep fall on two sessions, sending global markets into turmoil. The Indian markets kept stabilizing after each day of turmoil in the US markets. But these are more in the nature of a habitual “Buy the Dip” strategy adopted by domestic mutual funds and retail investors.
Two trouble spots for our markets are now amply clear. The curious question is where can the third trouble spot emanate from for our markets? Inflows into mutual funds seem to be stable and show no imminent sign of slowing. There are no imminent worries for investors. People seem to show ample confidence by buying into corrections. FII selling is a spot of bother. But, their selling seems to be getting absorbed comfortably. So where can the third spot of trouble emerge from?
One potential trouble spot can be the global bond markets. Bonds can put equity in a bind. And the trouble will possibly start with the US markets and rattle global debt markets. This will set equity markets up for an earnings reset. An earnings reset can potentially lead to a valuation reset. We need to have a more risk averse approach to investing. Expect more trouble.
“Recognizing risk often starts with understanding when investors are paying it too little heed.”– Howard Marks
Is the dream run over? Have markets crashed or have they paused?
One hears anxious investors simply abandon their confidence with every fall in stock indices. As the years advance and public participation in stock markets grow stronger, our patience for corrections simply isn’t enough. Our impatience grows on us, our peers, and on those who are watching the stock markets from the outside.
When markets correct even 3%-5%, a whole lot of doomsayers start getting louder and louder. They question the market’s stability. Questions tend to get louder and louder, building into a market chorus. The market chorus usually grows either into optimism or pessimism, depending on the overbearing sentiment.
For now, it seems like there is a sudden shift from extreme optimism to extreme pessimism. The reason is the imposition of a small tax on long-term capital gains. Interestingly, existing profits have been protected, making that tax only on future profits. This makes the market look utterly irrational in its behaviour.
Actually, this budget reminds you of the James Bond film Skyfall. After all the expectation and hype, it has simply failed to bring a spectacular close to the four year Modi rule. The climax seems to have bombed. Going by the market box office verdict, the ending seems to be rather abrupt. For investors, it is probably the time to be more pragmatic. One can take some solace in the lines of Adele’s much-awarded song, Skyfall.
“Let the Skyfall
When it crumbles
We will stand together
Face it all together
After all, India is the most promising global investment story for the next five years. It would be a tragedy to lose ourselves to near-term investment myopia. Budgets don’t change the direction or outcome of the Indian growth story, they only change the subplots.
“Return alone—and especially return over short periods of time—says very little about the quality of investment decisions.”– Howard Marks
Selling is never easy. Much as investors love profits and die to make more of it, when it comes to taking it, they hate to press the exit button. The overwhelming emotion when the finger heads towards the exit button is fear.
“What if you miss out on more profits? Would it not be a tragedy to exit early?” Doubt stops the right actions. Most investors who are overwhelmed by fear never sell. On the contrary, they buy heavily at market tops. And, when the markets correct sharply, they panic. Sounds familiar, right?
So what is it that can counter the new-high headlines screaming at you from the pink papers? Or the party buzz that is all around you. Or, the fear of missing out. There is only one thing that saves the day if you really want to save it for yourself. Contentment.
If you know things are really much better than you expected and everybody else thinks there is more to come, you need to just listen to yourself. Cut the noise out and take a few simple clear sell decisions. Then, execute them and walk away from the crowd. Don’t bother what happens for a few weeks. Or, even for months if you need to.
But remember that you were in the minority that took profits. The majority in the Indian stock market merely watch profits get created and destroyed. You are in the minority that redeemed.
“Most people are driven by greed, fear, envy, and other emotions that render objectivity impossible and open the door for significant mistakes.”– Howard Marks
Over the last year, Indian debt markets witnessed a lot of volatility. In early 2017 the consensus was that interest rates would continue to fall. On the contrary, 2018 begins with mixed expectations. While some believe that interest rates may fall, there is enough reason to believe that the RBI’s neutral stance and macroeconomic factors suggest otherwise.
Previously, crude oil prices were driven by demand conditions. However, of late OPEC and non-OPEC countries have created an artificial rise in oil prices by agreeing to cut down on production. These decisions may have been made in light of Saudi Aramco’s impending IPO. While this strategy may be effective in the short-term, it is unsustainable in the long run.
A hike in fuel prices has a direct impact on headline inflation. Yet, the RBI will maintain its cautious approach with interest rates and may not immediately react to oil price movements.
The Federal Reserve’s Actions
The Fed has been working consistently to improve various aspects of its economy. Economic recovery in terms of employment, growth, etc. has supported the Fed’s decision to reverse its QE program. Consequently, there has been a mild uptick in inflation. This has weakened the dollar. In turn, this is favourable towards higher exports and the Fed is consciously devaluing its currency.
The Federal Reserve will continue to raise interest rates this year. When interest rates are more attractive in advanced economies, money flows out from emerging markets. The RBI may raise rates to counterbalance this movement of capital.
India’s Fiscal Deficit
The ruling government overshot their fiscal deficit target in November. For a government that has otherwise been fiscally prudent, this is out of character. Lower tax revenues, lower dividend income, and higher spending contributed to this breach.
Adhering to fiscal deficit targets serve multiple purposes. Firstly, fiscal prudence improves creditworthiness. Second, a breach could affect macroeconomic health. A high fiscal deficit could result in higher inflation, increased taxation, and lower credit growth. Third, it results in a vicious cycle where future targets may be broken.
Taking the volatility in crude oil prices, the Fed’s actions, and our fiscal deficit into account, there seems to be little room for a rate cut. The RBI’s neutral stance could simply be an inflexion point.
The new year began well for the stock market. Both, domestic and foreign investors were buyers of equity. Global sentiment is predicted to be positive in 2018. Clearly, sentiment is a strong driver. Liquidity is seconding sentiment. We see the inflows into Indian equity at an all-time high. The amount of money mobilized in IPO’s in 2017 alone was more than the cumulative sum of the previous decade.
2018 surely promises to be an economically eventful year. Growth has to return. Investments must remain buoyant. The government will present it’s last budget on February 1 before it faces the voters in 2019. The stock market valuations seem to factor in all good news from the budget. There is expectation of both populism and reform. The budget possibly will be a mix of the two, with populism dominating.
January will see the usual budget speculation. In the coming weeks, we are likely to see enhanced activity and excitement in the stock markets.
“Successful investing requires thoughtful attention to many separate aspects, all at the same time. Omit any one and the result is likely to be less than satisfactory.”– Howard Marks
As we bid adieu to a wonderful investing year and welcome a new one, it’s time to pause and ruminate a bit. It is that time when we set our expectations. We actually need to assess how expectations played out in 2017.
Investment performance significantly outplayed our expectations in 2017. We did far better in the stock markets than in the real economy. That’s not unusual. Often, stock markets run ahead of the real economy. Now, economic performance needs to catch up with the stock markets. Can the markets keep running ahead of economic performance for two years in a row? While we can’t rule it out, it would mean that the economy will come under very severe pressure from the stock market. And, at some point in time, the stock market will lose patience and confidence.
The key factor to watch out for now is economic performance. This would be a shift from the company-focused approach that worked exceptionally well in 2017. The best thing to happen for investing will be the return of economic growth.
While the markets seemed unaffected by bad news in 2017, taking everything in its stride only to head higher, 2018 will certainly test its resilience and patience.
“The road to long-term investment success runs through risk control more than through aggressiveness.”– Howard Marks
The last week of a calendar year is usually the time when global institutional investors take a break. When they return in January, their investment actions are often radically different from those made in December. Just like a test batsman takes a fresh guard after a lunch recess, fund managers take a fresh view of things in the New Year.
When nothing changes drastically in the economy over a fortnight, what causes this sharp divergence in investment behaviour? Global fund managers realign their investment allocations across different markets. This often causes drastic shifts in their India strategy and outlay. Indian funds are usually left only with the option of responding to what global funds do.
Recent years saw domestic funds simply play counter strategies to what FIIs did. If they bought, we sold. And vice versa. The behavioural lead was always in the hand of FIIs, while DIIs were more reactive. 2017 changed this dramatically because of domestic investment flows. While FIIs did sell, DIIs took the lead buying and began driving our markets.
2018 will be an interesting year. It remains to be seen if DIIs continue to be the lead drivers or if we will have twin drivers or if FIIs will lead again.
“First-level thinkers look for simple formulas and easy answers. Second-level thinkers know that success in investing is the antithesis of simple.” – Howard Marks
If you are an Indian investor, asking the right questions now is the most important thing. The logic is simple – when the going is too good, it is important to question the sustainability of good times. The stock markets have done extremely well in 2017. This is evidenced in performance across equity categories. But, investor interest has been fixated mainly in select areas – the balanced, mid-cap and small cap funds. 2017 has predominantly witnessed domestic capital flow into these areas.
Risk taking which worked well in 2017, may not find it as easy in 2018. The reasons are simple. First, business performance is likely to change as economic growth patterns evolve. Next, investment performance will always chase emerging business performance. More importantly, when some sectors have been punished badly in one year, they could show improved stock market performance in subsequent years.
Investors must note that the equity categories which worked very well for two or three years at a stretch tend to stagnate thereafter for a while. In the dynamic investment environment that we live in, it is essential to capture the emerging dynamics, invest in areas where time corrections are likely, and to bet on the ensuing structural improvement of the economy.
Given the investment track record of 2017, this isn’t going to be easy. To walk away from immediate successes of the past towards what will succeed in the distant future is going to be challenging. Investing is about working towards the future. Only investors with a yearn for risk will find the right path to future investment success. Every December, savvy investors relearn the same lessons.
Risk means more things can happen than will happen. – Howard Marks
The coming weeks promise to be interesting. During recent months, domestic investors have put behind almost every market setback and resumed buying equities. Domestic liquidity has absorbed any selling by FIIs. Traders have also remained supremely confident on equities and we are entering December with the highest level of confidence.
Leverage is at an all-time high. We have seen most market favourite stocks regain price losses effortlessly and go on to make some new highs. Nothing seems to bother domestic sentiment. The Gujarat polls also seem to have been factored into valuations. We see investor confidence quickly absorb bad news and move on.
This is no ordinary scenario. Rarely have markets shown such gumption. December which is usually a nervous month, hardly looks threatening. There seems to be all-round domestic consensus on almost everything. Such a setting is usually perfect for an unexpected event.
The Gujarat poll seems to have raised expectations of a decisive win for the ruling party. Clearly, the market seems to be too sure. This sense of assumed certainty is usually a lose-lose situation. A win, as expected, for the ruling party will probably be already factored into the markets. This makes a decisive market rally very improbable. On the contrary, a shock loss is not something the markets are ready to quickly absorb and discount.
With fundamentals not supporting present valuations, too much is prefaced on liquidity and flows. Now, that is what we can call the perfect setting for a surprise market move.
December has been a month never found wanting for surprises. This December may not disappoint.
“All bubbles start with some nugget of truth.” – Howard Marks