2012 – Boom or Doom?

December 13, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

What a year 2011 has been. Except certain commodities such as gold and oil, every other asset class has been hit. With Sensex down more than 20 pct YTD, 10 year g-sec yields up by almost 1 pct and rupee down by almost 14 pct against the dollar, it has been a poor year for investors. This was caused by a bout of strong global risk aversion led by the European sovereign debt crisis, high inflation in emerging markets and consequent monetary tightening, and lack of proper policy action in India. The only salvation came from commodities such as oil (up almost 26 pct in rupee terms) and gold (up almost 38 pct in rupee terms).

Are any of these likely to continue haunting us in 2012? Or will there be a new set of problems? Is the worst already behind us? That’s the million dollar question on everybody’s mind. The irony is few of us, if at all, have the right answers. Still based on evidence available today, one can hazard a guess.

What does 2012 have in store for the investor?
There is no doubt that growth has slowed down. The poor industrial growth numbers over the last quarter and the latest second quarter real GDP growth of 6.9 pct (manufacturing growth was a mere 2.7 pct whereas mining output contracted) drive the point home.

Is it going to change in a hurry?
Seems improbable. After all, more than a year of continuous rate hikes should have taken its toll on growth. And to top it up, inflation is yet to subside at least on a year on year basis, even though that is not the best way to look at it. The fall in the rupee hasn’t helped either, exacerbating the already high trade deficit and inflation by making imports costlier.

But aren’t we pricing it all in? Aren’t equity valuations cheap and yields already near 2008 highs?
True. But stocks can get cheaper still? Markets can remain irrational longer than you can remain solvent. Remember, we are still looking at Sensex valuations with respect to FY13 earnings which price in a 16-17 pct growth over FY12. Whereas FY12 earnings growth is already being revised down to 10 pct, expected FY13 growth can be downgraded further if macro indicators worsen.
Also, the Sensex earnings yield (basis forward PE of 13-13.5 as per FY13 earnings estimate) at approx 7.5 pct is still short (approx 0.8 pct) of the one year bond yield. Historically, equity markets have come out of a bear phase once Sensex earnings yields have been higher than bond yields by more than approx 50 pct i.e. the ratio between Sensex forward earnings yield and bond yields has been around 1.5. On this basis, valuations seem to be in a fair zone rather than being screaming cheap. For Sensex yields to become 1.5 times of bond yields today either the Sensex will have to be de-rated further or the bond yields will have to come down significantly. It is unlikely that either of these events happen in isolation. Rather a combination of both, i.e. a price or time correction in stocks coupled with the bond yields coming off significantly seems to be a more plausible scenario going ahead.

The initial part of the year 2012 (probably the first half) thus might continue to see high volatility as a result of the above. But as we move to the latter half of 2012, things should start improving. Bond yields are most likely to have come down quite some distance by that time (assuming that inflation moderates — month on month growth momentum in core WPI inflation is already showing signs of slowing down — and RBI starts cutting rates) and equities should be available at a real bargain by then. The second half of 2012 should thus be much better than the first.

What should investors watch out for in 2012?
Key risks to the above outlook might arise from adverse developments in the outside world including but not limited to the worsening of European sovereign debt crisis, a recession in the U.S. and Europe or a drastic slowdown in Chinese growth. Each one of these events will have the potential to give rise to a renewed bout of global risk aversion which will not be healthy for countries like India that depend on foreign capital flows to fund their current account deficits.

However, the key is still with Indian policymakers. Nothing mentioned above will be able to bring us out of the quagmire we have let ourselves in, if our policies are not right. Chronic diseases such as high fiscal deficit, lack of proper infrastructure and policy inaction have to be cured if we wish not to remain at the mercy of foreign capital flows. Foreign investors’ confidence in the India growth story, which has taken a beating of late, has to be rebuilt or reignited at any cost. Doing business in India has to be made easier to attract FDI and generate enough employment to harness the potential of favorable demographics. Otherwise, the advantage could soon turn out to be a disadvantage.

What should the investors do?
Investors should be wary of getting caught on the wrong foot as most of us did in the early part of 2009. Avoid selling at the lows. The first half of 2012 might give you a big opportunity to buy, though it is tough to correctly guess the time when that opportunity will arise. Don’t put your money in illiquid investments or investments with lock-in periods if that money is meant for equities. You don’t know when you might need it.

Likewise, staying on the sidelines might not be the best thing to do in these circumstances. Staying invested in markets is as important as anything else for long-term wealth creation, though you might choose to go underweight or overweight in accordance with the fundamentals. And this is surely not a time to go underweight on equities. Rather it is time to stagger your investments over the next six months and build your portfolio by way of STPs or Systematic Transfer Plans from cash to equities.

Just sticking to your asset allocation can help
Sticking to the original asset allocation will be of great help in the long run, in the scenario that might unfold in the near future. For instance, if one is supposed to invest in equities to the extent of say 60 pct of the portfolio, let him maintain that asset allocation at present. Under the above strategy, further downsides in equities will lower the allocation. The investor should then proceed to buy more equities to bring the overall equity allocation back to the original. This will automatically bring down the overall cost of equities in the portfolio and enable significant gains once equities bounce back.

Key triggers that can make the markets rise again
Even though the environment remains less conducive for a rally in equities, there is a lot of embedded value in stocks which should make lower levels unsustainable leading to strong bouncebacks following downsides. In terms of triggers, strong policy action by the government to bring about structural reforms tops the list. It is heartening to note that some activity has already begun on this front, the recent decision to allow FDI in retail being a case in point. Apart from that a solution to the European debt crisis (they are able to find a ‘buyer of last resort’ for EU nations’ debt) as well as a moderation in domestic inflation coupled with a fall in yields also has the potential to trigger a recovery.

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