Stern warning by RBI: Markets must read the signals

RBI has finally decided to take on the inflation menace head on, and our markets must take cognisance of the essence of the stance taken by RBI. Despite the lip service by the Govt. in taming inflation in the past, inflation has moved from strength to strength in the past 18 months. The recent move by RBI should be seen as a very positive move to fight inflation, even at the cost of sacrificing a bit of growth in the short term. The hike of 50 basis points in Repo and Reverse repo rates announced today will be the main driver for the markets in the short run.

Bond yields have firmed up to 8.44% immediately after the announcement of rate hikes. Equity markets have also reacted sharply on the downside, shrugging the unwarranted euphoria of the past few weeks. The hardening of interest rates is bound to have a negative impact on the overall corporate earnings for FY 2011-12. The equity market valuations will be re-rated downwards in the weeks to come. The chances of an imminent crash in equity markets are fairly high given the overall global uncertainty. The major indices, which have been range bound for last 6 months, are likely to break the range on the downside in the coming 1-2 months. The correction could be in the range of 15-20% from the current levels. What should the investors do in this scenario?

• Long term investors can hold on to their stocks, if liquidity is not a concern.
• The market reaction to the monetary policy should be utilised to get rid of stocks that have come out with poor results. Stocks with high exposure to debt should be avoided.
• Investors who lack liquidity may sell at least 25% of their portfolio to generate cash, which can be utilised to buy the same stocks at lower levels, when the markets react.
• The focus should be on creating a buying list of stocks that have come out with good results, so that they can be bought on dips.
• The 'Risk-reward ratio' at the current market levels is not attractive for fresh equity investment. If one is looking at a one year growth of 20% or more in the portfolio, which an equity investor should look at, one should look for investment in the range of 4800-5000 levels on the Nifty, for a target of 6000 and above in one year.
• Interest rates on deposits for shorter tenures will see significant hikes in the near future, it may not be a bad idea to put some money in fixed deposits/ bonds for the next few months.
• Profit booking may be done at any bounce in the markets, in the range of 5600-5700 on the Nifty, which is the upper end of the current range.

The next few weeks are likely to see testing times for equity investors. Investors are expected to hold their nerves in the falling markets, and take a decision to invest in equity markets for long term when markets react on the downside. The Indian economy is likely to bounce back strongly in 6-9 months time when the inflation will be tamed and interest rate cycle peaks out. Remember, the 'Mother of all bull runs' is yet to unfold in the Indian equity markets, let us get ready for it.

Investors are Bulls at heart

Psychological studies reveal that investors are bulls at heart, and why not, the structure of our markets enables them to make more money on the upside rather than downside. Typically, bull phases last almost 2-3 times the bear phases. The last 2 bull phases would confirm this view: One of the longest bull phases on Indian bourses lasted 44 months from June 2004 (Nifty around 1500) to January 2008 (Nifty 6357). The ensuing bear phase was over in 10 months in October 2008 (when Nifty bottomed out at 2253). The next bull phase lasted around 25 months (Nifty topped at around 6300 in November 2010). Since then we have been witnessing a bear phase which is likely to get over by August-September 2011. Nifty which is currently trading at over 5700 is in the last phase of the ongoing bear market rally, which will give way to the impending bottoming out process which could take the indices down by 15-20% from the current levels.If we look at the brokerage recommendations the buy calls out number sell calls by 4:1. This also strengthens the view that long term investment in equities is always rewarding for the investors.

But It is always advisable for investors to keep on booking their profits from time to time to benefit from the wild swings in the markets. Indian stock markets are more volatile than markets in US and Europe, because of the shallow nature of our markets. Our markets are more prone to liquidity adjustments because they are by and large ruled by  Foreign Institutional Investors (FIIs) including short term hot money pumped by hedge funds. The current bout of bear rally has again been fuelled by this hot money, despite extreme dark clouds looming on the economic scenario in India and abroad.This makes the risk reward ratio in equity investment unattractive from a 9-12 month perspective. Investors who have made reasonable profits can consider partial profit booking at Nifty levels of 5700 and above, because the next fall could be severe. Despite this view the markets may show some strength till the middle of August, fuelled by better results declared by a few companies.

It would be interesting to look at the factors that could influence the sharp fall in our markets:

• Lack of Governance: the Govt. may give indications of some reforms as well a cabinet reshuffle soon. But come August, the Parliament session will ensure that the governance will be relegated to the background. The govt. is likely to face renewed embarrassment on the issue of tackling corruption. In fact, we can expect the extreme eventuality of a change in Govt. in some form before the end of the year.
• Liquidity crises: The present upswing in our markets is fuelled by excess liquidity. The liquidity situation is likely to reverse soon with the worsening of the crises in Euro zone and the gradual withdrawal of QE2. The flow of hot money from safe heavens like Mauritius could slow down keeping in view the regulatory changes in the offing.
• Real estate crash: A crash in real estate market, specifically in the housing sector, is long overdue. Once this happens there will be a huge negative sentiment on the equity markets. The chances of defaults in this sector are fairly high, considering the huge debt accumulated by a large number of Realtors. Only those construction companies would be able to survive the crises that have diversified into commercial real estate and infrastructure creation.

However, all the above factors would be extremely positive for our economy in the long run. Considering this, the next downturn in the equity markets will be a precursor to the 'Mother of all Bull runs' which would give an opportunity for massive wealth creation for investors. Investors should be guided by the age old adage 'Make hay while the sun shines', book profits at current levels and create liquidity for buying at lower levels.