Tuesday, September 16, 2008

Reasoning market behaviour – think the i-m-possible ?

Beginning January 08 markets the world over and Indian markets in particular have been correcting. What went wrong ?....Common answers (a combination of all and some of the below) 

  1. High oil prices, exerting an upward pressure in input costs…without an ability on part of Cos to right away pass on the costs
  2. Similar to 1 above is high commodity prices
  3. High inflation
  4. Rising interest rates ….(this of course followed from point 3 above)
  5. Massive unwinding in overseas market and the sub prime crisis leading to negative sentiment and a drying up of liquidity
  6. Most also buttressed the above reasons to add that the multiples at which Indian equities were trading were at very high levels though not as high as the dotcom boom or the 1994-95 boom levels.
  7. To further add to the reasoning – it was also suggested that all of the above would lead to a re-pricing of risk and therefore there will be re-adjustment of multiples. 

We are nearly 9 months into the correction? The situation now is as under :- 

  1. Oil prices have fallen more than 1/3 rd from their peak level of nearly $93-95 a barrel
  2. Commodity prices are cooling …except for agri commodities…where too I feel a supply side response is on its way…since it usually takes 2-3 years for cropping patterns to changes and efficiencies to show results
  3. Interest rates – most will agree are peaking …also in a globalised India…..India’s interest rates (exchange rate on the other side) cannot behave out of tandem with the rest of the world over a prolonged period
  4. Sub prime crisis losses can reasonably be estimated …some may not agree to this…but to my mind what can be estimated with reasonable certainty in an acceptable range (the narrower the better) is what the market looks for and operates on
  5. Most of the unwinding pursuant to point 3 has happened or the direction and the timing when it will be done is known
  6. Multiples in Indian markets have corrected by more than 35% (as measured by leading indices) and are now at similar / lower levels with what has been a median / average range over the last 15-20 years
  7. Re-pricing of risk -  this is arbitrary, but historically (as per various research papers and surveys) equity risk premium has been in the range of 5-7% …even if we add another 2% on account of high interest rate (to account for an increase in the risk free rate) and another 3% for the so called re-pricing as predicted in point 7 above…the cost of equity would be not more than 20%....Return on equity of the top 50/100 companies in Indian markets would very easily meet this criterion. 

But, I am yet to come across one commenter who now say that the markets are on their way of recovery. Most people who come on business channels / media would say the worst is yet to come ? we will wait for Q3 / Q4 etc results to take a view…..how does the US and the EU economies / markets behave etc….despite the fact that none of the reasons given by them earlier for the market fall do actually in full exist or it they do…then too the effect is waning. 

My own reading is as follows:- 

Five years of positive loop working (the bull market of 02-07- some still say this is on!) had built excesses in the real economy  (housing prices, food prices, metal prices etc). 

All will not correct overnight …some of it may get carried forward over longer periods…but there will certainly be calliberation…and mind you – this can be very violent as is being evidenced 

It has taken probably the 2-3 years to build the excesses…so evening out should take at least another year or more! this now is what is projected as a negative loop. 

If equity markets on an average over long periods to time (10-15 years or more) have provided 15-18% returns. …and the last 5 years have provided more than 30% returns ….the next few years will certainly compensate for the moving away from the average. 

Is this the negative loop or a natural calliberation? – choose your tag!

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