Equity market was in denial, catching up now: JP Morgan

Between 2003 and 2007, markets went up 7 times and created distortions in the minds of the investors and fund managers in terms of expectations of growth and valuations. However, Bharat Iyer, MD & Head of India Equity Research, JPMorgan says he would be extremely wary of using historic comparatives and extrapolating them over the future as global environment back then was different.

He says one has to be circumspect and cautious when looking at valuations. If one has to still look at it, then it would be preferable to further go back in time and look at what valuations were doing in relation to growth. Also Read: Caution! Mkt breaking down; won't buy India now: Geosphere
He says, in the current situation, valuations have limited relevance when earnings growth are so suspect. Besides they are strongly co-related with growth. Valuations will tag growth very closely, he adds.
He sees earnings growth at 7 percent, but even that looks at risk. He says Q2 earnings may be a disaster for financials which could flow into other domestic sectors quickly. He feels right now 6-8 percent earnings growth looks more consistent with the 5 percent GDP growth, but if the current mayhem in the bond market continues then there maybe substantial downside to current estimates.
He told CNBC-TV18, strong global and local macro headwinds have lead to prices falling. The equity market has been living in denial and it is just catching up now, he adds. The currency market perhaps has been more consistent in factoring in the macro challenges over the last 3-4 months, Iyer says.
There is a fair degree of frustration as far as global investors are concerned. They have been fairly overweight on India and what they have got in return is India is the worst performing market in Asia, Iyer says. There won’t be any relief for FIIs unless the rupee stabilises. As long as the rupee keeps depreciating, entire portfolio will be at risk because there is only so much that sectoral allocation within equity markets can do. If this state of affairs continues and things don’t bottom out, then it won’t be surprising to see capitulation in the next couple of months, he says.
Besides, 80 percent of the market was not performing and was at very low levels and only 20 percent was holding out and was pushing the benchmark indices, which couldn’t have continued for long. Contagion has spread and that is what is taking a toll on the equity markets.
He says in the near term, there is no other option but to go in for crowded trade, especially for those who are answerable on a daily basis on NAVs. But if an investor has 12-18 months, then it’s perhaps a good time to go bottom fishing in domestic sectors, especially in areas like financials. He advices investors to stay with IT, pharma, healthcare and energy until there are signs of rupee stabilising. Below is the verbatim transcript of Bharat Iyer’s interview on CNBC-TV18 Q: It has been a scary couple of days for the market, do you think the market is doing the right thing by bringing down prices now given the economic fundamentals?
A: I think the market is doing the right thing. If you notice for the last three-four months, the markets have been facing headwinds both from a global macro and local macro.
As far as the global macro is concerned, easy money seems to be coming to an end and as far as the local macro is concerned, growth is way below trend and policymakers have very little stimuli. The currency market has perhaps been more consistent in factoring these risks over the last three-four months. The equity market has been living in denial and finally it is catching up now. So the transition has been painful but I guess it is warranted. Q: In the interrelation of the two markets that you just spoke about, the rupee and the equity markets, where would you factor in the bond market and the fact that yields are touching nearly 9 percent today, how much of a factor is that, the fact that interest rates at least in the system have hardened considerably?
A: What is happening is the bond market is a second audit derivative of what has been happening in the currency market. The currency market is reflecting the stresses of a challenged macro and policymakers have very little option but to tighten liquidity to a certain extent to defend the currency and that is what is getting reflected in the bond market. Does that flow through into the equity market and stress it even more? Yes. Q: What do you hear from your global investors now? Is there a sense of disappointment at the kind of policy reaction we have started seeing over the last few days which has smack of desperation?
A: As far as global investors are concerned, there is a fair degree of frustration. Let us face it. Global investors are meaningfully overweight India. The average emerging market fund is 200 bps overweight on India and there has been a huge act of faith on their part in terms of pumping in money into this market over the last 18-19 months. What they have got in return is India is the worst performing market in Asia this year in US dollar terms. So there is a fair degree of frustration.
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As far as policy is concerned, it is easy to bash policymakers but to be fair to them over the last one year, we have seen a fair degree of policy response be it structural, be it cyclical, be it tactical. On the structural side, we have had reforms in energy pricing, we have had more open door policy in foreign investment.
On the cyclical side, we have had faster clearances for projects and on the tactical side, we have seen a host of measures over the last couple of months. What we have to reckon with is that structural measures will take some time to play through in my assessment about 12-18 months and tactical measures are being offset by a very challenging global macro. That is what results in the problem that we are facing currently. Q: Do you think the rupee market will continue to be a disappointment for global investors because that needles them every morning when they look at the NAVs, the way the depreciation is continuing, do you think this painful period will continue for a few more weeks and months?
A: I guess so. There is no relief for them until the rupee starts behaving itself because there is only so much that sectoral allocation within equity markets can save you because as long as the rupee keeps depreciating, your entire portfolio is at risk and that is the reason why we are seeing the kind of capitulation we are seeing over the last two-three days because we have been seeing a discord within the equity markets for sometime now.
80 percent of the market has not been performing and is at very low levels whereas 20 percent of the market was holding out but that cannot carry on for too long. The contagion is spreading and that is what is taking a toll on the equity markets. Until the equity market stabilises, I don’t think there is any need to call the bottom for the equity markets. Q: What do you do or what are you recommending with the crowded trades now because that list is getting smaller, it was probably 35 percent of the market now 20 percent of the market is pretty much IT and pharmaceuticals, are you still asking them to stay there or is it getting too crowded a trade?
A: From a portfolio allocation point, it is perhaps getting to be a crowded trade but over the near-term, there is no other option. If you have 12-18 months, you have that kind of timeframe then it is perhaps a very nice time to go bottom-fishing in the domestic sectors particularly in areas like financials but if you don’t have that kind of timeframe and you are answerable on a daily basis in terms of NAV, there is no point to change asset allocation on a sectoral basis at this point in time.
We have been for nearly six months now recommending a very defensive posture and been recommending that investors stay with IT services, healthcare and energy and we are asking our investors to stay there until they see signs of the rupee stabilising. Q: We haven’t seen much by way of capitulation yet given our macro, the way the currency has moved, one may have expected to see far more FIIs selling, do you suspect that may unfold in the second half of the year or will people just sit on their hands and ride out this rough phase?
A: We have seen it to a certain extent in the debt market but you are right, we have not seen it in the equity markets. It is a matter of timing, there is a lot of frustration building up because as I mentioned to you earlier investors are meaningfully overweight on India and if this underperformance continues, everyone wants to bury the evidence and that pressure will start counting on them, which is the reason the next couple of months are going to be very important and very challenging. If this state of affairs continues then don’t be surprised to see capitulation there as well.
_PAGEBREAK_ Q: What about the big end investors to many of these funds, do you think these many of these fund managers who are still sticking with India might be increasingly under pressure if they are faced with questions from their larger investors on why they are sticking to underperforming markets like India?
A: I guess that pressure will start mounting particularly if this space continues because they have been meaningfully overweight on India and they are meaningfully underweight on some of the other emerging markets, which has been performing very well, which is the reason I think the next couple of months is very important because there is only so much push back you can give your investors given the kind of underperformance they are facing.
As far as they are concerned, things should bottom out quickly and if that does not happen, yes, the question you raised is very relevant but I guess from a global investors point of view also you have to distinguish between cyclical pressures and structural pressures, the problem most emerging market investors are facing at this point in time is while India may look bad cyclically, structurally it looks a lot better than some of the other markets, which compete with India for allocation. So you have Brazil or a China, which perhaps are cyclically looking better but they have their own structural issues and that is where I guess emerging market portfolio managers are having a tough time balancing between the structural and cyclical at this point in time. Q: What have you done to earnings expectations because in January a lot of people were talking about 14-15 percent earnings growth, I just heard someone this morning talking about 7 percent earnings growth, how much have you brought it down?
A: We are in the 7 percent camp and we have been there for the last couple of months but I guess even that is looking at risk at this point in time. Because let us face it, financials are 30 percent of the benchmark and given where 10-year bond yield is right now, unless policy makers give banks some accommodation in terms of how they want to price these assets, the Q2 earning season could be quite a disaster for the financials. That could very quickly flow into the other domestic sectors as such. Right now, 6-8 percent earnings growth is more consistent with a 5 percent gross domestic product (GDP) growth but if the current mayhem in the bond markets continues, there is substantial downside to current estimates. Q: Talking about Sensex valuations now is a difficult exercise because of the extreme dichotomy in sector valuations, but we are probably at 13.5-14 P/E now, do you think given the fundamentals this time, by the time this market bottoms out, we could get dragged down to those 11 P/E multiples where bear markets have typically bottomed out in the past?
A: I wouldn’t be surprised to see that because on valuations two comments, one is that valuations have limited variants where earnings growth and earnings numbers itself are so suspect. So I guess one has to keep that in mind.
The second issue is that valuations are very strongly correlated with growth. If you were to look at a long-term valuation chart of India from 1995 to all the way to 2013, we had a space from 1995 till 2003-2004 where the average multiple for the benchmark indices was closer to 12 times forward earnings because that was the phase when GDP was growing at about 6 percent. Subsequently we had GDP growth picking up to about 8-9 percent and the markets also rerated and average trading multiple was about 14 times.
The question we need to ask ourselves is that if the GDP growth is going down to about 6 percent again for the next two-three years then is the 14 times forward multiple relevant anymore and if not a 12 times forward multiples more relevant? So I guess valuations will track growth very closely and that is what we need to look out for. So could the markets derate? I would expect it to, yes. Q: That is the most important point that you raised because in all these past averages etc that we look at, we have that everything factors in that four years of 2003-2007 when the markets went up 7 times, do you think that has created distortions in our head in terms of expectations of both growth and valuations?
A: I would be very wary of using historic comparatives particularly over the last seven-eight years and extrapolating them over the future. That was a different global environment both in terms of growth as well as in terms of availability of funding. That is perhaps not likely to get repeated so one has to be very circumspect and cautious when looking at valuations. I don’t think the valuation band over the last five-six years is particularly relevant. If you want to look at historic comparatives, I think go further back in time and look at what valuations were doing in relation to growth. So that is something the market may have missed in the last three-four months when it held out in higher valuations.