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Equity at crossroads

Indian equity markets are at a cross road. The bulls are disappointed as the Sensex is still trading at the same levels as in the second half of CY07.

Stock-specific approach and contra-strategy could give better returns in equity and gilt markets, going ahead

Indian equity markets are at a cross road. The bulls are disappointed as the Sensex is still trading at the same levels as in the second half of CY07. On a five-year basis, equities have given disappointing returns. The bears are disappointed as the Sensex is not correcting adequately in spite of all the negative news.

Budget proposals on retrospective amendment of tax laws and GAAR, policy paralysis, corruption, deteriorating macro environment etc. have made investors negative on India. The change in the outlook from stable to negative by S & P has also confirmed their worst fears.

The bulls feel that the rating agency has poor standards. If not poor they have double standards. One for the American and European countries and another for the Asian and African countries.

India, which has not defaulted to foreigners since the beginning of recorded history of man kind of more than 4000 years-which has lower debt to GDP-lower fiscal deficit to GDP- lower tax to GDP ratio compared to much higher rated nations and whose policies have not created debt crisis or sub prime crisis since 1991, is rated much below its fair value.

The bulls take solace from the fact that YTD FII flows in equity markets of more than $8.5 billion is one of the highest. The FII holding at 18.4% of market cap is the highest in the last three years. FII flows in debt market is so strong that there is hardly any space left to invest in gilt and bond market even after enhancement of limits. FDI flows at $50 billion for FY12 is the highest ever, with flows visible even in sectors like manufacturing.

GAAR is prevalent in most of the developed countries and hopefully it is behind us with the deferment till FY14. Yukos?s liquidation in Russia, mining giants? executives being jailed in China, BP?s liability for oil spill in the USA are similar if not worse than retrospective amendment of tax laws by India.

At least in India people have access to a truly independent judiciary system unlike in many peers. While bears fear withdrawal by FIIs, bulls believe in continuation of YTD trend so far.

Slowing growth, depreciating rupee, higher oil prices, tight liquidity, higher inflation and consequently higher interest rates, policy paralysis are all making bears worried on macro environment. Bulls feel that India has issues but can be solved easily unlike in the western world.

The rupee is depreciating as the geo-political risk premium has kept oil prices high and gold imports are almost equal to the trade deficit in FY12. If oil prices and gold imports come down then the pressure on rupee can ease off.

RBI has cut policy rates by 50 basis points in April 12 to support growth. RBI will manage liquidity and rates through rate cuts, OMOs and verbal intervention for the rest of FY13 to support growth. Inflation will remain elevated but could benefit from normal monsoon. Any drop in oil prices is a good omen for suppressed inflation.

Growth is slowing down in the absence of investments but is likely to be higher than many peers. So much is talked about policy paralysis that some action might be taken in a coordinated manner to change the perception. Bears are looking at the past deterioration of macros. Bulls are looking at actions which can be taken to stop the deterioration and improve the macros.

The equity market is evenly poised between bulls and bears, between optimists and pessimists. It is likely that markets will remain range-bound for the near term. It will not go down sharply as expected by the bears as valuations are fair. It will not go up sharply as expected by bulls unless actions are taken on the ground to improve the macro situation.

A bit of luck in the form of lower oil prices, lower gold imports and better monsoon will provide support to the bulls. Risk off due to deterioration in Europe and the US will provide additional support to the bears.

An investor will have to brace for volatility in the rest of FY13. There are many variables from global factors to local factors that will swing equity markets. It will be important for investors to focus on values rather than prices.

The biggest advantage of the Indian market is the sheer diversity it provides. Investors in consumer staple, pharmaceutical and technology sector are having good returns on their portfolios in last five years even though the Sensex has been flat in that period. A stock-specific approach in pharmaceutical, banking and financial services and small caps could provide better returns going forward.

Meanwhile, fixed income markets have witnessed tight liquidity since May 2010 . They also saw a long period of policy rate hikes to manage inflationary expectations. It also bear the burden of slippages in the borrowing programme of the government by a significant amount in FY12.

FY13 provides an interesting opportunity in fixed income markets. RBI?s unexpected cut in repo rate by 50 basis points in April 12 has been negated by the issuance of gilts. Gilt yields will move up on the back of large issuance, expected overshoot in borrowing programme, likely rise in the inflation in second half of FY13 and the overall liquidity situation.

As said, RBI will try to bring down yields by policy rate cuts, open market operations and verbal interventions. This push and pull of variables will move yields in a volatile manner but with in a range of 100-125 basis points.

Investors will have to focus on entering and exiting at the right yields to make money in the gilt market. The discipline of playing contra by buying in the environment of rising yields and selling in the environment of falling yields will generate better returns in gilt market.

Obviously it is not going to be easy as it will require the discipline of holding onto positions when returns could be negative to low. For the buy and hold kind of investor, short-term securities up to three years will provide a balanced opportunity of good yield as well as moderate price appreciation.

Short-term securities are yielding good carry due to tight liquidity and are likely to benefit if policy rates are cut or liquidity is enhanced to support growth, going forward. For the high bracket tax payers, FY13 will provide opportunities in tax free bond market.

The budget for FY13 has provided for issuance of R60,000 crore in tax free bonds. This is a fairly large amount and will keep yields at attractive levels in both primary as well as secondary markets. The gap on yields in recent primary issuance of taxable corporate debt and secondary market traded yield of tax free bonds of comparable rating is too narrow to sustain and makes a strong investment case for tax free bonds.

In some sense FY13 is unlikely to be different from the rest of the years. Markets will behave some times as per expectations and most of the time against expectations. Equity as well as debt markets will be volatile.

With the benefit of the hindsight we will develop new vocabulary like sub-prime and LTRO. The discipline of contra-investment, focus on bottom up stock selection and the art of buying when prices are below value and selling when prices are above value will work well for investors like every time.

The author is director, Axis Direct

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First published on: 14-05-2012 at 01:29 IST
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