Macro | A Paradigm Shift For India's Retail Investors?

The Indian economy is at an interesting point. We had two large scale policy moves in recent time - the much controversial Demonetization in November last year, and the implementation of (a somewhat rundown version) of Goods and Services Tax regime this year. Early this month, we had the first GDP print following these two major steps. The headline prints came in lower than consensus - 5.7 percentage for Q2 vs. 6.5 (and 6.1 last quarter). This was followed by equally weak Industrial Production release. A stronger than expected headline CPI prints did not help, as this squeezes the room for any rate cuts from the RBI.

A closer look at the GDP data (see component break-down in the chart below) shows some serious weakness. The private consumption part (C) has weakened significantly following the demonetization (the vertical red dashed line). The investment component (I) has been weak for a while (although staged a comeback in the last quarter). Exports growth was not helped by a strong rupee. In last few quarters, government expenditure helped the headline a lot. But the sustainability of this is questionable. We will have the fiscal deficit data out later this month. But the street does not expect anything great.

The story of the IIP paints a similar picture (see chart below, overall IIP, manufacturing, base materials, consumer durable, consumer non-durable, capital goods, electricity, intermediate goods and mining respectively). While demonetization appears to have caused a negative shock, in general most of them peaked out before that, around early 2016 to be fair. The capital goods, which staged a minor comeback since bottoming out in 2014, again resumed the downward trend, along with most (except consumer durable, and to some extend mining).

This is all in a relatively benign global macro scenario. In spite of the Fed taper 2.0 announcement, we have little jitters in the markets. Rates, both global and local, are relatively low and volatility remains subdued. Oil prices remain range-bound. A rally in oil along with a weakening INR following Fed and expected ECB taper later this year can worsen the scope of fiscal stimulus. Most in the business sectors does not expect private investments to turn around before end of this year at the earliest. The investment exuberance back in 2004-06 left many corporates laden with unmanageable debt burden and bank balance sheets with NPA.

In this background of weakening macro story, the Indian equity markets is in a tear. The flagship NSE Nifty Index posted a YTD 21%+ gain, among the best globally and compared to it's own history. The trailing 12-month PE ratio is looking worryingly high. High valuation remains a big concern among investors in this, and most other traditional metrics (a bit better in terms of price to book).

However, comparing the PE ratio to its historical average is not very good way to capture everything that goes on to determine fair price. In the most basic approach, the price of equity is a function of market risk free rates (say the local sovereign bond) and equity risk premium. Following the approach in this paper from AQR, I modeled the BSE SENSEX P/E based on the risk factors - the bond yields as well as the equity and bond volatilities (as in the original paper) along with current account balance as a percentage of GDP (reflecting the fiscal risk of the economy) and spread of bond yields to US Treasury (captures the flow risks). The last two are more relevant for an emerging market economy like India. The time-series shows a marked shift in relationship between pre- and post-crisis era. I fitted the model only on (monthly) data from 2010 onward to capture the recent dynamics. As it turns out, the bond vol has little contribution to market risk premia for India. The bond yield and equity vol shows significant but low correlation, whereas the CA deficit and spread to treasury captures a significant portion of the variance. The chart below shows the fit on this model (adjusted R-squared ~0.72).

According to this model, the PE ratio is only slightly on the over-valuation side - not a cause of great alarm. According to this model, the market was highly over-valued around late 2011, and early 2015. We saw corrections in both cases. Also the under-valued period, early this year, was followed by upward corrections as well. This model does not forecast a large correction anytime soon unless we rally up a lot quickly from here (obvious caveat: these are in-sample results).

But what is most interesting, and perhaps most significant is the recent flows that we have seen in Indian equity markets. Traditionally, the equity markets in India has been shunned by a large portion of retail investors. The experience of scams in 1990s and the melt-downs, once during dot-com busts and another in 2008, did not helped. The foreign portfolio investors dwarfed the domestic flows in cash equities for a long time (although it is a different story in F&O). But since 2014, something changed. The extra-ordinary flows in to the equities markets, led by domestic mutual funds (presumably on the back on retail savings channeled to equities) completely outpaced the foreign flows.

Is this a mass optimism following the 2014 election outcome and equity rally? Or are we witnessing a major shift in the savings behaviour of retail investors in India. The retail money has missed the initial come-back equity rally following the 2008 crash, and a part of the early 2014 rally as well, where the foreign investors made out handsomely. But much of the late rally in Indian equities has gone to the retail pockets. Is this dumb money chasing recent gains? We do not know for sure, but as we argued above, we are some distance away from any valuation melt-down in Indian equities. And the flow signifies the loss tolerance of the retails - who are sitting on some comfortable profits - has quite a bit room before panic. And finally, the weakening property markets and demonetization may have incentivized a permanent change in retail behaviour.

We do not know for sure. But what is the implication if it is indeed a fundamental shift in savings behaviour? As argued above, the macro in India is down, but with policies properly executed, the turn-around can be sharp. If oil remains range-bound and the Fed and ECB do not stray afar from the implied forward curves, we will have little in terms of global shock to upset the local economy. On the other hand, the efforts to put banking sector NPA in shape, along with the full kick-back of the GST regime should significantly improve the badly needed private investments. Add to this mixture this retail savings paradigm shift, and we are looking at the very beginning of a multi-year rally in Indian equity markets.

Nifty: Small Caps vs Large Caps

Focusing back to Indian Equity markets!

The interplay between small cap and large cap has been very interesting back home, compared to global benchmarks. For last couple of years, S&P 500 and Russell 2000 more or less matched each others performance. In late 2013/ Early 2014 the small cap index outperformed, which is now reversed by a relative under-performance. Compare this to India. Ever since the financial crisis, the market recovery has been led by the large caps. Small caps (or mid caps) consistently under-performed, except since last June. The election saw a large out-performance by the small caps, but otherwise it has been pretty much dull. Small caps premiums has been in fact negative.

We take a look at the financials to see if there is any clue there. Below the aggregated balance sheet for Nifty 50 stocks, vs. Nifty Mid cap 50*

And here are the corresponding PnL figures*

* All data from Bloomberg as they report. I think more or less the trend is captured here.

As we can see, one large issue with the small cap balance sheet is in general total indebtedness. Since 2007, both the large caps and small caps companies increased their sales 2.3x, with an increase in balance sheet in the 3.44x/3.42x range. However while for Nifty companies it has been funded 70% by non-current liabilities, for Nifty Mid cap 50, the figure is at 80%. Both not great, but mid cap definitely worse. On top, the figures for small caps were worse to begin with. So the current levels look far from comforting from investors' point of view.

On the other hand, as far as the standard valuation parameters are concerned, on both revenue and balance sheet related metrics (like price-to-sales or P/E pr P/B) large caps are slightly overvalued (relative to historical spreads).

So overall it is not a straight forward call. Small caps are undervalued, but not by much as they were before mid 2014. At the same time, the overall sector balance sheet looks vulnerable to any interest rates shock. The question is if that valuation compensates for the leverage risks. Given the current outlook, probably this will tilt in the favor of small caps and mid caps over all. But not without a constant watch. I will definitely avoid any adventure in this space.

2015: Points to Ponder

As you gear up for the year end, here a list of things and points for the next year. To mull over, without any iota of attempts to forecast!

1. Oil: from peak-oil to freak oil. And how the story unfold will be driving a lot in 2015. IMF Direct (the blog from IMF) had a very interesting piece on this recently. They estimate unexpected lower demand can account for only 20% to 35% of the price drop. And they find little evidence of financialization. In this context what is surprising is the speed of adjustment. For 2015 most analysts maintain gloomy forecasts for oil. Perhaps rightly so. But a lot of that comes from forecast of continued lower demand from China and Europe. Given the lower contribution of demand in the price change (as above), and the still volatile geopolitics of a large part on the supply side, the question remains what if there is a strong come back of oil price in 2015? It will mostly reverse what we have seen in 2014. The hysteresis loss will be for new investments in oil sector with renewed long term risk assessment; and in Europe, especially if the ECB had not gone through with the QE by then.

2. Russia: very much related to above. Will they get out of it? yes if the oil price bounces back. What if it does not. That is the hard part to speculate. On the face of it Russia does not look particularly bad on economic parameters. Yes, the inflation is running a bit high, and the GDP has slowed down. But they have been there before. The missing links are current account weakness, ruble appreciation reversal, and the possibility of capital flight. Krugman explains the first two of them here. The last part is the hardest to explain and quantify. See here, for example. And in my opinion this is the most crucial make-or-break factor. Russia will survive in the short run if the oligarchs have a lot to lose otherwise, and if Putin survives.

3. Wage growth: That will shape the Fed policy to a large extent. We have already seen some encouraging trends. 2014 has been a great year for job growth in the US. 2015 might as well be a good (perhaps not great) year for wage growth. If that is supported by lower oil price, it is good. If that coincides with a sudden rise in oil price, that can spook the market and push up break-evens and rates.

4. Housing: One of the weakest part of the so far good enough recovery of the US, is the contribution of housing to the investment component and hence the economy. The flow of funds from the Fed has consistently shown continued deleveraging in mortgages while consumer credit picked up. The higher mortgage rates and increasing prices did not help it either. Historically the contribution of housing to GDP is near record low. And that to me seems like a lot of upside in 2015.

5. Europe: If we have a Grexit start of the year (or even a panic towards that), that will greatly ease Draghi's case for an all-out QE. European equities missed out a lot compared to elsewhere, and can benefit from both improved earnings and re-rating. As I mentioned before, I think people are unusually bearish on Europe now (just like they were unusually bullish a while back). If you think the US equities are done with most of the run, and Abenomics not really working for Japan, and missed out the Chinese rally and now scared of the EM, you do not have much choice. On the rates side, a lot of the curve flattening has been driven by global influence and a re-pricing of the long end. I do not think the rates market is nowhere near as confident of a QE as most analysts are. The European swap markets now looks hardly any different from Japan. And with much much better upside.

6. Abenomics: And speaking of Japan, which I frankly do not understand much, all I say I do not see Abenomics working. The problem with that is if Abenomics does not work, the challenge for the subsequent governments will be progressively humongous. What are the odds that we will stop to see the yen rallying in a global panic? And what are the odds we will actually see yen selling off in a panic? I will keep rolling my yen shorts. In good times or bad.

7. China: Perhaps most discussed. One good thing about China for traders and investors is that China, with its mighty central bank and strong command control hardly produces any large surprise for the markets. (Of course the antithesis is that when the surprise does come it will be huge and bad, but somehow I do not buy in to that yet). With the rally belying the economy, the central bank and policies will be in the driving seat.

8. The bull run in India: I am a believer. Well for one, the benefits of the large oil re-pricing on India is still totally lost in the panic about EM. In fact India has been a net importer of non-agri commodities. So recent secular weakness is a huge bonanza if they sustain. In terms of valuation it may not be cheap, but much scope remains for earning improvements. 

9. Return of volatility: A sustained period of low vol can be policy driven (when the central bankers become sellers of vols), or it can be just a phase of a complex system. Because low vols just happen some times. FX has already seen some uptick in vols. And yes, commodities of course. May be time for the rest.

10. What else: move away from rotation to diversification? a policy-driven liquidity crisis? year of the frontier markets? crisis in Europe? middle-east mayhem? HY melt-down? comeback from the UK? Wide open. As always.

Best wishes and a happy new year

NIFTY: Day traders Vs. Investors (+ A Christmas Present !!)

Here are some interesting charts comparing how S&P CNX Nifty has performed over last many years - split between day-session performance vs. overnight. The pattern is very interesting. In 2007-2008, the day traders dominated, both in profits and in losses. Be it the run up to the pre-crisis top in early 2008, or the crash. It was again the day traders who profited most in the comeback in 2009. This continued till the peak in 2010. 

However, after that, something changed. 2010 was the last great year for the day traders. Since 2011, the overnight returns dominated returns during the day session, far and steady. That was the case during the mild bearish runs in 2011, the sideways market in 2012. And the trend continues strongly in to the current bull period. 

The overnight returns now dominates day session so much that if this continues, going long overnight and shorting the markets during the day is now a super profitable strategy !!

What is driving this? Well to start with: the vols are down, and NIFTY (like most emerging markets) is perhaps influenced by the Feds and the BoJ much more than it used to be back in 2007. I would suspect most emerging markets will show very similar patterns. And this is VERY different than, say , S&P 500, where overnight and day-session has their fare share of misery and joy.

Will this continue? Well, the flow of funds that world-wide QEs initiated is still churning around, and will perhaps take a long time before the dust settles down. But it is an altogether different scenario if we enter a high vol regime in 2015, irrespective of market direction.

The tail piece: for folks looking for public source of intraday data on stocks - here is a quick and dirty R scripts. Feel free to use and modify as you please. Quantmod of course does a wonderful job for daily data. This routines are similar and extend to intraday.

Downloading intraday data from Yahoo or Google

. Merry Christmas and happy holidays everyone!

NIFTY: Technicals - Choose Your Divination!

Now with the budget out of the line, we will be trading relatively event-less in near term more or less. So focus is less macro and more micro, stock-picking and timing the markets etc. In case you rely on technical indicators, here is a quick summary of what works and what does not among the weapons in the technical traders' arsenal for NIFTY. All data from Bloomberg.

The first chart shows the total performance of different strategies based on technical indicators, against simple buy and hold. The whiskers show the maximum and minimum annual returns, while the thicker bar s show the average annual returns in a trending market and in a range-bound markets (it is white if trending return < range bound return and black otherwise). The data spans 2004 to YTD 2014. The trending years are identified as 2004 to 2007 and then 2010 and 2014.

The second chart shows the relative rankings of strategies in a given year (1 is the best, 23 the worst). Again the whiskers show the best and worst ranks over the years and the thick bars show the average annual ranks in trending as well as range bound markets (again, it is white if the average trending rank is lower than, i.e. better than, average range bound rank)

So based on this if you believe we are in a trending market, NOTHING beats the simple strategy of buy and holds. And if you think we are in a range bound market, the best performing strategy is a variation of moving average (Triangular moving average - a three-point double-smoothed variation of the moving average method, with majority of weights in the middle point).

In general, you are better off following Ichimoku or different variations of moving average methods in a trending markets (if buy and hold is too simple for your taste!). And in range bound market also, the moving averages perform relatively better than other complicated indicators. But even then, they do not beat the simple buy and hold strategy by a large margin.

Of course, as we all know, past performance is not indicative of future returns.

NIFTY: Inside Stories

Reported insider selling has been quite active lately for Indian listed equities. So we take a quick look at it

Looking at the graphs, here are some stylized facts

1) the inside selling activity has been most wide spread recently. Although the total value of gross and net insider selling has come off the peak in April 14, the number of companies involved is still much higher than last few years average

2) The aggregated inside selling does not appear to be a good predictor of the general direction of the market. It seems, the company insiders are usually happy to lock in a local maxima after a slump in price.

3) Give 1 and 2 above, it may not be time yet to worry about the end of the bull market

NIFTY: Are FIIs Really Overweight India?

I have my doubts

Here is an interesting article from the good folks from FTAlphaville

What is striking is that although the general feeling is that the FIIs have been "euphoric" about India and its' resurgence under Mr Modi as the PM, as I see, the data fails to show the same. Here are couple of charts to drive home the point.

So irrespective of what analysts at foreign banks says, I think a large part of the rally in the Indian equity markets so far this year has been driven by domestic buyers or may be even retail money. And a lots of potential FIIs flows sitting on the sidelines. Through the last phase of the election campaigns and actual elections, my perception is that FIIs have been cautious and decided to follow a wait and watch policy. And it would not take a dramatic positive results for NDA to kick start the next leg of the bull run. A simple confirmation of average exit polls prediction will do.

Yet Another India Vs China Story

A very interesting piece from IMF Direct blog!

It captures how the trade integration within Asia has phenomenal compared to other regions globally for last two decades, centered on the China growth story. And it also highlights how this has resulted in increased synchronization, and increased propagation of growth shocks between regional partners. This, is claimed, has given rise to a high correlation among Asian economies, as they provide this chart for quick evidence

And when I look at this chart, I find India has a pretty interesting position. In fact some might argue, based on this chart, that betting on a Chinese shocks can be structured through short Australia and Korea and long India and Philippines, adding statistical leverage.

Although I am doubtful this negative correlation in economies will translate to the correlations in markets in the event of a severe chines slowdown. Irrespective of how good or bad the economic story is, India will face consequences on international financial flows if we see a real serious slow down in China. The question is what happens when the dust settles down. India is a net importer from China, with some overlaps of export to other developed countries. So certainly will suffer much less directly through a slowdown in China. In fact can even benefit from reduced competition in global markets. But by any means economic downturn of the second largest trading partner is no good news, even if it runs a net trade deficit.

But if the slowdown in contained, I think there will be some focus on this issue and India will see some part of the flows from the Asia focused funds, trying to limit Chinese exposure

In fact, long-term market correlation supports this. NIFTY has been much more correlated to S&P 500 ...

... than Shanghai Composite

NIFTY: Election 2014 Positioning... Eliminate Tough Decision Making

The current move in NIFTY, expected to end in a crescendo after the elections, is probably one that will be the defining move this year. If you have already missed the rally so far, or fail to capture the large expected moves after the results are out, your portfolio performance is probably doomed for this year.

The question is do you really give a damn. You are in the game for the long term, right? it does not matter if you miss an election move or two.

So... a first strategy for election 2014 is, well, DO NOTHING. It is so often overlooked in the heat of things that doing nothing can turn out to be a pretty neat strategy. If it rallies after the results you will capture it anyways. If it sells off, you were buying value right? So unless we have a radical outcome, it should be an opportunity to buy.

Okay, now let's say you DON'T plan to do nothing. Here is a way to think about your move. 

Like poker, in markets too, apart from the goal of making money, another important objective is to avoid tough decision. Because tough decisions are always emotional, and that is exactly when you are most likely to make mistakes. And avoiding tough decisions in future is achieved simply by making choices now that makes your decision easy later on.

So let's apply this rule to see how you should be positioned. First thing first. I have no clue which way the market will move from here. Nor does anyone. Let's assume for argument's sake, the market has an equal chance of a large rally or a correction from here. If you go short now, and it does make a correction, congratulations! You made it. Now what if it does not? You make a loss on your shorts, AND you miss the rally. That's okay, no big deal. But what next? can you enter it now? You thought the market was already on the higher side and then it rallies quite a bit more. All you are going to do is to spend the next 6 months on the sideline waiting for a dip. A large one at that. You missed the entire 2014!

Now the other side of the bet. Suppose you went long. The market rallies. Well done. Now you take a re-look at the valuation and decide further action. And what if it corrects. No big deal. It just offers a more compelling valuation then. Way better outcomes no matter if you are right or wrong

And that's the kind of bets to make. Because with markets, the probability that your views are right is not much different than pure chance

NIFTY: Great Expectations?

Here is a fantastic background for India 2014, more so for the uninitiated! (Do click)

And now the questions is how much juice left in this rally and which sectors are really overheated. Below a snapshot of the relative performance of different sectors vis-a-vis the benchmark (NIFTY) index. As you can see the rally that started late last august once quite contained. But the pre-election rally (a possibility I noted before) has been, well, fantastic. With all the usual suspects racing away - only Energy, Pharma, FMCG and IT still lagging.

The question is what now. Obviously the pattern of the rally since March shows a lot have been on expectation of a radical shift in policy after the elections are done with. PSU banks, Real Estate, Financials, commodities and energy sectors especially seem to have performed on this expectation. How realistic these expectations are - a few wise words from JP Morgan (via FTAlphaville)

The belief in certain quarters is that as long as the next government were to go all out at de-bottlenecking projects, sentiment would surge and this would spark an investment revival in the economy. However, this appears to be an overly-simplistic read on the situation for at least three reasons.
First, the vast majority of projects are currently stuck because of issues that are under the purview of state governments, over which the central government has little jurisdiction...

They also warn of the circular link between the bank bad loans and stalled infra projects. Do go read the full text. 

One thing is sure, we do have rallied a lot on expectation. Or rather hope. That is not saying we can't rally further. But given the uncertainties of election outcome, the tail risk of hung parliament results may not be a tail risk. That can rattled the market which seem to have priced in too many rosy assumptions

Trivia: Dance of Democracy

The election time is here again in the largest democracy in the world. Here is a link from an old post back in 2009 (the last general election). A mathematical awakening for all those lost in debates over Mr Modi's ghosts from the past, Mr Gandhi's incompetence, Mr Kejriwal's lack of direction and irrelevance of others. 

Actually the only system that will work for you is a dictatorship in which YOU are the dictator!!

Jokes apart, democracy is built on institutions. I honestly don't mind lack of leadership, as long institutions  are strong. If you think a country is a super example of a complex system, it is far better for it to walk randomly and find direction through evolution and time, than hurtling at Mach 2 in a direction under a great leader only to realise later as a nation it was wrong direction to begin with. 

Have a great time voting. By the way the implied volatility levels where the options on Nifty are trading, my back of the envelop calculation shows if u want to cover the time decay from now till the election results are out, the volatility levels should be around 50%. That will be higher than the 2008 crash!

In Charts: India Under NDA, UPA-I and UPA-II

Presented without much comments

Note on the time periods
1999-2004: The BJP-led NDA government
2004-2009: Indian National Congress-led UPA-I
2009-2014: UPA-II from 2009 till date.

The Growth Story: GDP annual growth. Both suffered external shocks. The recession following dot-com bursts in early 2000s, and the great recession of 2008.

India Shining: The unemployment rate. Well the sharp change in the last figures, may be NREGA? This is just one side of the story. What about productivity? An income guarantee scheme may be good for headline unemployment numbers but not necessarily for the economy, at least structurally. I would say NDA scores.

Fiscal Responsibility: Debt to GDP. UPA scores. But story does not necessarily add up, see the fiscal balance and this chart together. Perhaps we are missing some pieces to the puzzle. Disinvestment incomes saved the day for UPA II? I need to research more on this point.

Twin Deficit Part I: Budget Balance (% GDP). UPA-II has the worst figures, but it also suffered from 2008 financial crisis and its after math (and the fiscal stimulus).

Twin Deficit Part II: Current Account to GDP. NDA scores hands down

The Common Man's Pain: Inflation (Compared to US Inflation - white line). NDA came in power after the peak in 1998. UPA II sees an alarming rise in inflation despite softening of global inflation. NREGA?

Rainy-day Fund: Forex Reserve Growth (YoY). NDA scores, hands down

These are just dumb charts, and incomplete without the story behind them. I do not see a clear winner here. But it seems UPA-II on the whole worse than both NDA and UPA-I