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Be Defensive, Stay Contrarian

The genesis for the current meltdown in Indian markets must be understood well and remembered for a long time to come. Interestingly, the indices held steady during this period.  So, what caused this downslide?

Broadly, the markets showed overwhelming faith in smaller companies over the index bellwethers between 2015 and 2017. The poor performance of index bellwethers like tech and pharma during this period contributed to the heavy concentration of investor interest in midcaps and small caps.

The belief that small and mid-cap companies will be insulated from macroeconomic challenges grew on the investor psyche between 2015 and 2017. During this phase, investors gradually moved away from large caps and raised their exposure to midcaps, small caps, and even microcaps. The heavy concentration of fund flows clearly raised returns and valuations in this phase to all-time highs. Valuations spiked up leading to a premium in midcap valuations over even the indices.  This unusual trend persisted for months together. Investors knew this was unusual. But, nobody was ready to go into cash.

It is under these circumstances that valuations in midcaps cracked. With economic macros like exchange rate, oil prices, and inflation turning the markets may be on the cusp of a new trend. This is a good time for contrarian, defensive investing.

Anchoring Bias

Podcast Transcript:

My stance on mid-cap funds has been bearish in a while. After the dream run between 2013 and 2017, I started to feel very uneasy about them from September 2017. I had been advising clients to invest in the very funds when the valuations were softer and definitely attractive. But once these valuations went behind levels I consider reasonable, I turned cautious.

Firstly, I was advising clients to avoid investing aggressively into mid-cap funds. Then, I advised them to gradually move their monies into safer parts of the market. The decisions seemed out of sync with what industry was telling customers. Every dip was being bought and it appeared the best thing to do. The mid-caps simply kept going higher after every fall. This made investors believe that every dip must be bought. Implicit was the belief that the stocks will only go higher.

The current capitulation in mid-caps is also being bought into based on the same belief. The fact that stocks went higher after every previous occasion is why people are hurrying to buy this dip. But, this time could well be different. The reading of investors could well be wrong. Here is why.

We are thinking that the high valuations of 2017 are the new normal. But this belief has little or no basis. It is merely a demand-driven phenomenon. Now, supply promises to be abundant in quality equity paper. This only means we are going to see scarcity go away. Finally. So, sustaining valuation in a supply driven market will turn to be a challenge.

Investors seem to be ignoring the headwinds ahead. The reason is simple. Anchoring is biasing them. It so happened that everyone who bought previous dips made good money. That is biasing investors heavily inducing them to aggressively buy every dip.

But we are not necessarily going to be right going forward. There could be a long period of lull when performance could be ordinary. It is doubtful if investors will show the required patience in mid-cap funds for such a long time. Negative returns or non-performance may even get punished. Redemptions cannot be ruled out. If, and when they happen, they could be a major spoiler. We are going to see smarter investors selling into rallies. This would mean those buying the dip and not selling the rally may suffer in the end.

Rising oil prices and interest rates can dampen earnings. This may well lead to contracting valuations. As valuations fall, it can well lead to a reverse spiral in stock prices.

This turns anchoring biases into a grave risk. We need to be aware of what can happen if the situation creates furthers fears in investors’ minds. And what if the fears refuse to go away?

I believe we now need to avoid anchoring biases. The times are different. It is important to be in sync with the emerging market context. Anchoring biases may now prove to be very costly.

RBI Monetary Policy, June 2018

Monetary Policy:

As the macroeconomic outlook becomes less transparent the monetary policy committee has only become more steadfast in its neutral stance. This leaves room for all possible outcomes and actions. The neutral stance has often been equated to a status quo for policy rates. So, the rate hike of 0.25% may come as a surprise to some.

Inflation has always remained at the core of policy decisions. Oil prices have already increased by 12% since April. More clarity on global oil prices may emerge after OPEC’s meeting later this month. Till date, price hikes have been passed on to the end consumer. Raw material costs have also spiked as a result of this. The RBI anticipates an upward inflationary trend and is working to manage this.

On the other hand, India’s growth story continues to remain positive. A normal well-spread out monsoon bodes well for the agriculture sector. Urban and rural consumption look healthy. Capacity utilization in the manufacturing space has improved. The resolution of stressed assets is ongoing and better provisioning norms are ultimately working in favour of banks.

Investment Strategy:

Rising bond yields should be viewed as investment opportunities rather than pain points. The RBI’s neutral stance does not provide a clear view of where interest rates are heading. Risks are elevated when there is less clarity. Asset allocation will play an important role in mitigating risks.

Play It Safe

“Large caps look inexpensive compared to small and midcaps.” A value investing peer said this in a rather complaining tone. To investors who made most of their wealth buying small and midcaps, these are troubling times indeed. The situation has remained so for the past year. Investors have been struggling to cope with this. Stocks were expensive and people were buying them as if there was no tomorrow.

Nothing contrasts this frustration more starkly than the bold and aggressive SIP flows into the same space from retail investors. Investors have been pouring money into this space based on past returns. While experienced investors struggle to deploy money in the space, public investors were partying with the monies of the retail investor. But, the first signs of cracks are clearly there. For starters, stocks which were not owned by mutual funds have corrected sharply. This gives a false impression that fund owned stocks are safe. But, there is more to this than meets the eye. Fund owned stocks in the midcap space will correct when the funds are not in a position to support their prices. It is fairly safe to assume that day shall come.

Meanwhile, the market struggles to find defensive investments in equity. Portfolios will take an increasingly defensive stance and returns over the next 12-18 months will probably see better traction in defensives. Aggressive investment strategies will probably take a break. The time is ripe to stoutly defend portfolios.

 

The Wall of Worry

Interest rates are a great leveller. They always set the trends of the equity markets. But we have two sets of rates to contend with, domestic and global rates.  Domestic interest rate trends are constantly shifting and puzzling. Just when the trend seems set to rise, something happens which softens the trend. Signalling by the government also plays its part in softening the trend just when rates harden up. The absence of a guidance only makes matters worse.  But,  US interest rates are clearly heading north. We are guided on both the trajectory and extent of rate hikes. The guidance is unambiguous.

Markets constantly play on rate expectations and actual impact. When expectations are more benign than impact, markets tend to gain. When the actual moves hurt more than the markets anticipate, we are going to be in for a negative surprise. While the US markets are not likely to surprise, the domestic debt markets never fail to surprise the equity investor. We will have more worries coming our way from the domestic macros, rising US interest rates, and the debt markets in 2018. If and when the markets climb the dual wall of worry, it could end up being a huge positive surprise for equities. But that could still be a long way off.

Fixed Income Outlook – April 2018

Market Outlook:

Volatility has struck debt and equity markets in equal measure in 2018. Valuations continue to remain an area of concern with respect to equity markets and volatility will continue to persist until earnings match valuations. This is a global phenomenon and is not restricted to domestic equity markets. Meanwhile, investor appetite for debt has reduced.

Our core strategy team has been working on attractive investment options within the fixed income space. Our strategies are expected to outperform traditional investments like fixed deposits (one-year) by 1% to 1.5%. Hedging your portfolio through proper asset allocation will help mitigate risk. To explore your investment options please get in touch with your relationship manager.

Global Sentiment:
Positive growth indicators and tame inflation are facilitating the Fed’s policy to hike interest rates. Globally, advanced economies are expected to follow the same cue. Interest rate hikes across the board could induce volatility in emerging markets like ours. More importantly, threats of a trade war, rising crude oil prices, geopolitical tensions, and protectionist sentiments could further pose threats to stability. Currencies are expected to weaken, as countries compete for exports and try to manage deficits.
Monetary Policy:
 The RBI’s neutral policy implies that a data-driven approach will be followed when it comes to managing the economy. Any adjustments will be made in a calibrated and gradual manner. The focus is on resolving stressed assets, improving transmission of policy rates, keeping inflation within the target range, and fostering an environment for higher economic growth.
Domestic Markets:

Bond yields have remained at elevated levels for a variety of reasons. The government breaching its fiscal deficit led the market to believe that there would be an oversupply of government bonds. Markets anticipated that the government would borrow more heavily in the current year. However, its announcement to restructure the borrowing program by following a more staggered approach using instruments of varying maturities has pleasantly surprised investors.

The recent scheme recategorization has created a more transparent and investor friendly system to understanding the classification of mutual funds.

Strategy:
Risk management always plays a central role in any investment strategy, especially when it comes to debt. A well-constructed portfolio should be able to weather uncertainties and deliver returns. To discuss hedging strategies through asset allocation, do feel free to reach out to our team.

Keep Your Chin Up

When markets correct sharply, where are you looking?  This question assumes special significance as the indices are down 10%+ from this year’s highs. And the lows don’t seem imminently near.

Effectively, we are now in a market where everybody has overplayed their hand. And, when you have overplayed your hand, the day will come when you simply can’t deal. There will be no money left to buy equities. That’s a simple rule of market trade.

We are yet to reach that point in this correction. But, it is almost certain that that point will be hit and even breached. When a breach happens, the pain will be unbearable. Selling will become overdone. The consequences of such breaches will be upon us for an extended period of time. While we warn of such impending pain, it is important to understand that there is a very big opportunity that’s before us.

It is coming at us. Slowly, it will build up and grow. We must learn how to play an opportunity as it grows right in front of our eyes. We must also play it carefully so we are in a position to deal with every opportunity when it presents itself. We should not become helpless spectators on that day when the markets are most irrational. We must keep our hand ready, prepared and willing to deal.

One fine day is waiting to come at us.

 

“Investment defense requires thoughtful diversification, limits on the overall riskiness borne, and a general tilt toward safety.”– Howard Marks

Volatility Returns

Politics makes a huge comeback in the stock markets, exactly when the markets are not ready for it. Unlike other market disruptions which pan out as standalone events, politics sets off a trend resulting in a series of events. Throw in a few economic events from time to time between the political event sequence and you have abundant volatility.

 


Fear gets freely manufactured and manifests itself in a secular way. Extreme fear rarely spares company valuations. At best, it affects a few companies less or it hits them late. Early volatility tends to hit companies which don’t have strong institutional backers, have higher free float, and have a broad based ownership. It later spreads to all companies when buyers aggressively withdraw and sellers start to queue up.

 


We still haven’t seen volatility spread and it has remained restricted to pockets. Secular volatility in the markets can make a very different impact altogether. For the moment, it doesn’t seem to be on the anvil.

 

“The degree of risk present in a market derives from the behavior of the participants, not from securities, strategies, and institutions.”– Howard Marks

Preparation Hour

The Indian markets started 2018 with an exaggerated sense of optimism. Clearly, headline numbers were lagging the markets. As the market moves towards the end of a financial year, that exaggeration is swiftly disappearing and getting replaced by fear.

We could see an overreaction on the other side too. And, investors with little or no exposure to previous cycles are going to be the most reactive to these trends. The challenge before us is not how we manage our investments but how we manage ourselves.
When investments do very well, we stop managing ourselves. We cease to follow the path of good sense and tend to get carried away.  Investments cannot always take care of themselves. They need our active management when their valuations go out of whack. To achieve that, we need to manage ourselves and stick to the path of reason.

The fact that the market was way off the path of reason is now coming home to hurt. While the excess valuations are swiftly correcting now, we don’t know where it can lead to. Stocks tend to become cheaper than we expect them to. We need to manage ourselves well to ensure we don’t let go of that opportunity to invest in equities.

From the need to sell equities aggressively early this year, we could swing to the other extreme where we may need to be buying aggressively. Clearly, we are in preparation hour.

“You can’t predict. You can Prepare.”– Howard Marks

Play Safe Now

A not so innocuous news report by a global brokerage set us thinking about where we are headed as a market. ” $1.2 billion waiting to get into midcaps says CLSA”.

The logic behind this premise interested us even more than the actual premise. The premise was that mutual fund schemes needed to change their portfolios to comply with certain new regulatory norms. To our minds, this looks every bit like a mindless exercise driven more by compliance needs. The logic of selling what you own with conviction and buying what you need to own by category is surely a blind spot. Impact costs are clearly going to hurt investor interest. They come at a time when fund NAVs carry a lot of price massaging. Clearly, the timing of reform in mutual funds is nothing short of awful. And, the impact is going to badly hurt investors.

Investors must steer clear of midcaps for a while. Let the pain settle down. The coming months are likely to be driven by global factors and volatility. Focusing on micro changes in our markets simply won’t help. This is a time when investors who fail to play safe are setting themselves to be sorry later.

 

 

“The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological. Investor”– Howard Marks