Our Notes: Bull or Bear from here?

Dear Ace Readers,

The pandemic called corona has altered the way we live & work with massive ripple effect on economy. It’s onslaught continues since March 2020 (for India). We hope all of our readers are staying healthy and practicing social distancing.

Stock market’s reaction to corona has been very surprising. Firstly the nose-dive which happened in early phase and then the V shaped recovery within months. Honestly, rally was expected after oversold markets in April but no one expected it to happen so soon while corona situation is still evolving. We are still seeing cases rising in US, Brazil & India. Surely, the worst is yet to come.

This rally has been phenomenal, there are questions if it can sustain or continue to grow or start to taper off. Experts are divided over it. We are also not here to predict what exactly will happen from here. It is best left to astrologers. What we can do is to provide inputs from both sides of the equations to help you get a sense of it.

Market rally from the 52 weeks low
Sensex : 42%| Midcap Index: 39%| Smallcap Index: 44%

Away from the 52 weeks high
Sensex : -12%| Midcap Index: -15%| Smallcap Index: -13%

The Bull Case

Brokerage houses & stock market experts, being bullish on stock market are citing primary reason as liquidity. Globally interest rates have fallen and G-Sec or T-Bond 10 years yield has fallen back drastically. Recent data shows US T-Bond 10Yr yield is 0.6% whie G-Sec for India has fallen to 5.8%. This means investors will shun debt instruments in search of better returns. At the same time cost of capital in India is at 4% while in US it is 0%. This means investors can raise money at almost nothing and put them into securities which they thinks opportunity exists. Such security after global stock market meltdown was equities. Naturally, heavy selling followed heavy buying. Emerging markets make of it.

In such scenarios, the perceived reward-risk ratio is higher in developing nations because of :
a) US dollar will weaken with oversupply, leading to export oriented emerging markets to prosper
b) More for India – Oil prices also went down resulting in cheaper input costs for Indian companies

Another, line of thought coming from experts in accounting is purely quantitative. It says that stock markets have already priced negative outcomes of corona and are looking forward to FY22 earnings.
Typically, while predicting intrinsic value of a company, the predicted cash flows from next 10 years are taken into the account. This is DCF (Discounted Cash Flow) Accounting. It is widely or shall we say, the only tool to quantitatively define true worth of a company. The intrinsic value. Even start-up are also valued using this method. There are some assumptions related challenges in this method but that is for some other day. So the argument is if corona takes away let’s say 6 months of cash flows from a company and assuming efficient market hypothesis, this should result in only 6/120 = 5% share price decline. Add another 5-10% to respect market sentiments. Maximum of 10-15% correction would justify corona led correction but what we saw back in April was -35% correction in the index itself. So, this was clearly oversold market and ripe for a come back.

The last and more interesting point of view is coming from visionaries. They say, with anti-china sentiments more business will flow towards other emerging markets like India. At the same time India has a demographic & skills to replace China in global supply chain. This case is pretty strong & viable for industries like Pharmaceuticals, Chemicals & Textiles where India has been very competitive. The rising wages in China is also causing it to loose the cost advantage over India. At present labor cost in India is around $1 per hour while in China it stands at $4 per hour. It is only matter of skills and scale. Skills will need some time to develop in non-traditional industries and scale can come from financial sector. If these two happens, theoretically, India can easily replace China in most industries.

The Bear Case

Corona virus pandemic ceases to relent. In India we have seen daily cases rising from 8000 to 15000 to 25000 over last few months. Clearly, we are yet to reach at the peak before it will start to subside. Healthcare experts predict cases will hit a peak around November time-frame and winter will make it hard to stop. So peak can be flatter & longer not conical. In our view, given the low death rates due to corona the main worry should be the lack of healthcare infra. There are grossly inadequate beds available for contagious diseases. With all focus on corona, other diseases will get a free hand. Hospitals are turning hostile to admit new patients and private hospital bills are sky rocketing. All this will lead to higher secondary impact in India which will be due corona induced panic situation. Naturally, in such situation, we cant expect economy or stock market to perform when people are struggling in their daily life.

Another bear market point of view is based on valuations. Index valuations are getting steep with P/E at 28 times. This is 55% higher than index’s long term average of 18. Historically, whenever market have reached to anything beyond 25, the fall back has been imminent. With more depressed earnings in future, the index multiple will only go up even if stock prices do not rise. This will lead to a perception of bubble in Indian stock market and mean reversion theory or simply law of average will catch up sooner or later. Hence market seems frothy and outlook bearish.

So, Bull or Bear?

We think, both arguments have good points and we are at a juncture where it is extremely difficult to judge the market direction. So let us divide our outlook into different parts:
a) Over short term, market may remain insane. Infact they may becomes more insane due to money sloshing around the world. Defying all logic of fundamentalists.
b) Over medium term, market should see some more waves of mini corrections. It won’t be as drastic as April but sort of cooling off the valuations. So investor with long term horizon should keep some cash in their kitty to use such opportunities.
c) Over long term, market will recover and perform well again. Specially the mid and small cap space as they are trading much cheaper than large caps based on earnings growth capabilities. People with monthly investment methods should continue to do so.
d) Over long term, if you are stock specific or have a focused approach to investment, it does not matter where market is headed. The broad guidelines is for people who invest in index funds or mutual funds. For people dipping into specific stock story, they will continue to do well in long term irrespective of market direction. We have seen companies like GMM Pfaudler going up by 8 times in last 3 years which was a very bad period for small caps. There are many such examples.

We think, this article will provide you a round up on most think tanks out there on stock market. Give it some time to sink in. Decide what works best for you. What kind of investor are you. What goals do you have in mind and associated time-frame. Once you are clear with your own thought process, decision making is much easier to implement with conviction.

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Stay Safe & Healthy!!