Wednesday, August 31, 2016

Equity markets are overheated: Do not reflect Economic fundamentals

Indian equity markets have entered a danger zone, and a severe fall can not be ruled out once global liquidity dries up. Equity markets made new highs today with Nifty touching 8800 during trading hours. Markets seems to have discounted all the good news, however, seem unconcerned about the impending domestic & global concerns at this juncture. Most of the analysts are misleading the common investors by giving absurd targets for the indices in the days to come. I would like to caution the investors about the challenges faced by the global economy, which are likely to have an adverse impact on our equity markets.

Domestic issues: The GDP figures for the first quarter of this fiscal, released in the evening, have exposed the weakness of the economy. GDP for Q1 has slipped to 7.1% as compared to 7.9% for the previous quarter (Q4 of FY 2015-16). Industrial growth is down to 6%, Agricultural growth is down to 1.8%. The day has been been saved by Service sector growth at 9.3%. More worrying news comes from the Fiscal deficit front where the Govt. has reached 73% of the budgeted target within the first 4 months of the year, implying that it will exceed the Fiscal deficit target by a huge margin. Despite passing of the GST bill, the Govt. is not fully prepared for its roll-out from April 2017. The prediction for an above normal monsoon had been discounted by the market, but the progress of monsoon reveals that its distribution has not been up to the mark. The markets are again irrational in discounting the impact of  'Arrears paid to Govt. employees' as the same is likely to be inflationary in nature.

Global scenario: The global markets are flush with stimulus funds which are driving equity markets to crazy levels, far ahead of fundamentals. I would like to mention 3 inflection points which would lead to a negative slide in our markets:
1. Interest rate hike by US Federal Reserve: The oft postponed rate hike is now inevitable, it is likely to be announced in September. This will lead to strengthening of the US $, leading to the flight of capital from equity markets to safe havens like US treasuries, Gold & Silver. It would also have a negative impact on our already shrinking exports to developed markets
2. Impact of Brexit: As euro-zone prepares for Britain's exit, the instability would lead to drastic cut in Capex budget in the euro-zone and consequent decline in IT exports to these countries from India. New regimes in UK and US are seen moving toward stringent immigration laws, leading to a fall in global Indian companies operating in or supplying to these countries.
3. Financial turmoil in China: China's growth has been an enigma for the entire world, but now the cat is out of the hat. The next round of global instability is likely to be inflicted by China, as the country's debt has been mounting to unreasonable levels. China may resort to further devaluation of its currency to stem the rot, but it may have a cascading effect on developing markets, and India is unlikely to be spared.

In such a scenario our equity markets will need to correct substantially, to make them reasonably priced (Nifty index currently trades at a PE multiple of over 23, as against the average of 14-16). Nifty index has had a non-stop run from 6825 to around 8800 within the past 6 months. A reasonable correction from these levels would take the Nifty in the range of 7800-7900 levels (a 50% retracement of the recent rise). Investors are advised to book substantial profits at the current level, and wait for a correction to around 8000 levels on the Nifty to re-enter again. The fall in Mid-cap & Small-cap stocks could be much deeper.