Don’t Sweat. Not Yet At Least

Has the run-up in the stock markets exhausted itself? The pundits seem to think so. Mostly, the arguments in favour of bearishness come from the fact that the minds of these worthies have got ‘anchored’ to a nominal figure, like the Sensex number.

“Anchoring” is one of the flaws in our thinking, wherein the mind fixates on an initial number, no matter how arbitrary it is. The situation is very similar to the pattern seen in our purchasing habits, where the shopkeeper quotes a high figure, say, Rs.1000 for a purse. This is just an initial negotiating point, which tends to become our reference point for future negotiations. So we negotiate for a discount from that initial number, even though it may have no link to the actual value of the goods being purchased. So a purse that is worth Rs.100, gets sold for Rs.800, with the buyer happy to get a “bargain” from the initially quoted figure of Rs.1000.

We see this flawed thinking among those who argue that the “Sensex is too high”. Any index is a derivative, whose value is derived from the value of its underlying assets. Mostly, the argument against this has constituted of “value”, ie, the calculation of P-Es and expected growth rates in profitability. This constitutes the “fundamentals-based” argument in favour of Indian markets.

There is a technical argument too. It is made up of the “big trend” towards a revaluation of currencies across the world, which will lead to a re-balancing of currency portfolios among international money managers (FIIs).

In 2004, the US Dollar, depreciated further against major currencies such as the Euro, the Swiss Franc, and the Yen. The US Dollar lost even more in value against some of the more exotic currencies, such as the Polish Zloty (+23.9%) and the South African Rand (+18.1%).

The other best-performing currencies against the US Dollar were: Colombian Peso (+18.1%), Hungarian Florint (+15.7%), Iceland's Krona (+15.6%), South Korean Won (+15.6%), Czech Koruna (+14.9%), Slovakian Koruna (+14.8%), and Romanian Leu (+11.3%), while the Swiss Franc appreciated by 9.10% and the Euro by 8.02%.

Marc Faber points out that in Euro terms the Dow Jones declined last year by 4.5% and the S&P 500 was up by just 0.9%. By comparison, German bunds were up by 10% in Euros and 19% in US Dollar terms. So, when pundits forecast an S&P 500 level of 1,350 or higher by the end of 2005, they need to specify at which level of exchange rates the US Dollar will find itself. After all, in an inflationary environment (asset inflation), domestic asset prices can be boosted by an expansionary monetary policy, but at the corresponding expense of a weakening exchange rate.

Alternatively, US monetary conditions could tighten and reduce asset inflation in stock/bond/housing markets, at the same time boosting the value of the dollar, especially with reference to the Euro.

The strong appreciation of the Euro and other European currencies over the last two and a half years has led to a very significant overvaluation of the Euro against the Asian currencies, which, since the beginning of 2000, have hardly moved against the US Dollar.

Whereas since January 2000 the Swiss Franc, the Euro, and the Pound Sterling have risen by 35%, 29%, and 14%, respectively, against the US Dollar, over the same period the Japanese Yen is up by just 3%, the Singapore dollar by 2.5%, and the Taiwanese dollar is down by 3%. The Euro in turn has performed strongly against the Japanese Yen and the Singapore dollar, which has led to a relatively low valuation of Asian assets expressed in Euro terms (despite their appreciation in US Dollar terms). The Singapore stock market has almost recovered in US Dollar terms to its year-end 1999 level, whereas in Euro terms it is still significantly below that level.

Largely due to currency movements, Asian asset values (equities and real estate) seem to be relatively inexpensive compared to the rest of the world.

Since all asset prices have risen strongly over the last two years, it needs to be remembered that rising commodity and real estate prices lead to inflation in consumer prices and so to dwindling demand. Rising interest rates follow inflation, which then depress bond and equity prices. This is what we see happening in US markets.

But India and maybe Asia, seem to be much lower in the inflationary cycle. A re-balancing of currency portfolios would see a drop in Euro allocations, largely because of the technical reasons outlined by Faber above. Fundamentally too, the Euro zone does not have the growth momentum that Asia (particularly India and China) has.  

Portfolio flows would then gravitate to Asian currencies, with the Rupee (among others) as a major beneficiary. Given the underlying fundamentals of 6-7% expected growth, >15% growth in profitability and a Market P-E around 15, a lot of money would flow in, wanting to take advantage of relatively higher interest rates. This would create a bullish cycle, which would be self-fulfilling. Portfolio flows would ultimately serve to keep interest rates low, pushing corporate profits up and hence stock values. That would mean that a 15% increase in Sensex would seem reasonable, after it has reached a base Market P-E of 15.

From a trader’s perspective, it would therefore make sense to stay on the buy side till the Sensex goes up to a current P-E of 17-18 (15% over a Sensex P-E of 15). Assuming a small 3-5% appreciation in Rupee over the short-term, a foreign portfolio manager would find it profitable to get a 10% return from Indian markets. If he gets, say, 5% Dividend Yield from a stock, no capital appreciation and 5% currency appreciation, he should be quite happy.

Assuming that he gets a widely available 2% Dividend Yield and the currency return, he needs little trading incentive to invest in Indian equities. Although he might want to stay in Large Caps, and make quick exits whenever the situation demands.

So it would be fair to expect that, based on the above “currency play argument”, foreign flows into India will continue, with short and increasingly sharp fits and starts. That would increase volatility, with a mean value around a current Sensex P-E of 15-18.

The above argument is a theoretical one. The flaw in it is “single factor thinking”, ie, the tendency on the part of many analysts, to take a single factor and study it threadbare. The increased focus on this single factor, leads the analyst to ignore the impact of myriad other factors. Among them would be political factors, demand slowdown, corporate indebtedness/ credit cycle, etc.  

But to those who fear a sudden and sharp reversal of foreign flows, simply because of the increased dependence of Indian markets on them, there should be some comfort. In the current scenario, we are still not in (relative) bubble territory, as far as the international portfolio manager is concerned.