Has the Sensex run out of steam? - The 5 Minute WrapUp by Equitymaster
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Has the Sensex run out of steam?

Jun 11, 2009

In this issue:
» James Grant takes a crack at the US Fed
» How much gold does one need to own?
» Why have global commodity prices risen?
» Auto ancillaries shy away from acquisitions
» ...and more!

India and Brazil seem to be the most happening countries right now with Wall Street being the most bullish on stocks in these two regions. What has fuelled optimism is the anticipation of strong growth of both these economies and the belief that they present the best risk-reward opportunity as far as emerging markets are concerned. Infact, as reported on Bloomberg, Brazil's main index rose 42% this year. In India, the BSE-Sensex has moved up by nearly 89% since March 9, 2009 largely driven by the frenzied activity on the institutional side as the FIIs have pumped in more than Rs 300 bn.

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So given that the recovery process will take some time in making a significant impact, is there more steam left in the Sensex after the recent rally? Does one need to be cautious while investing in the stockmarkets? The Sensex currently is trading at a price to earnings multiple of about 20 times. This was 12 times before the rally began and is historically believed to be around 15 to 16 times. Therefore, if one wishes to view this from an FY11 perspective, considering that we expect returns of 12%-13% on a CAGR basis from the Sensex, the earnings of the companies that comprise the Sensex will have to grow at a CAGR of 27%, which looks a tall order indeed if the nominal GDP growth rate is in the region of 10%-12%. Thus, unless there is a significant re-rating of the Sensex, where in the P/E remains the same or goes even higher, things do not look rosy for an investor from a FY11 perspective. He will have to rely on his stock picking skills to achieve any outsized returns.

He's not known much in India, but James Grant, the publisher of Grant's Interest Rate Observer in the US, is a force to reckon with when it comes to ideas in economic and financial matters. In a recent interview to a US business channel, Grant has taken a crack at the US central bank - Federal Reserve.

He writes, "If the Fed examiners were set upon the Fed's own documents - unlabeled documents - to pass judgment on the Fed's capacity to survive the difficulties it faces in credit, it would shut this institution down. The Fed is undercapitalized in a way that Citicorp is undercapitalized." Bold statements, indeed!

On gold, Grant is a bull. As he writes in his latest column in Forbes, gold is to be bought for macroeconomic considerations. This is unlike stocks and bonds, where value investors buy based on the underlying fundamentals of the instrument itself rather than based on how the economy will perform.

As he writes in his column, in case of stocks, "...whether the gross domestic product is rising briskly or not at all is immaterial if a particular company is priced at less than its readily ascertainable net asset value...but gold is something different. You buy it solely for macroeconomic considerations. I buy gold as a hedge against the stewards of paper money."

So, you need to own gold to hedge against the macroeconomic policy blunders. But the confusion for you, the investor, must be - How much gold I need to own?

Well, as suggested in a widely read financial newsletter Daily Wealth, gold should be around 10% of your total portfolio. This suggested allocation comes from Jean-Marie Eveillard, whose First Eagle Global Fund has beaten the stock market every year this decade. What is more, this out-performance has come despite Eveillard not taking big risks.

Eveillard's fund is currently around 10% invested in gold and gold mining securities. His explanation for his favour for gold is - "It's insurance to protect against the fact that current policies by the American government and the Fed are potentially wildly inflationary."

How is recovery really shaping up in the real estate sector in India? The real estate sector received a real drubbing when the crisis erupted as demand for homes fell, compelling industry players to lower prices. It appears that this move has helped to a certain extent as demand for home sales seems to have inched up. However, this cannot be construed as a major recovery, which is likely to be some time away, as buyers await further reductions in prices.

Builders, on their part, have been doing away with their focus on premium housing and affordable housing is now forming a bigger part of their agenda. Further, a slew of interest rate cuts have also lent a ray of hope to builders that demand for homes will once again start kicking in. But are prospective buyers convinced? Not really as they contend that the ground reality has not changed much. Expectations are still palpable of further reduction in prices but builders are wary of going in for any more lowering of prices. Once again, recovery in this sector, if any, will be feeble in the near term atleast.

Slight rise in prices
Image Source: The New York Times
The global economy is throwing up pretty mixed signals currently. As per estimates, Chinese exports fell 26% in the month of May, meaning that the major economies like the US, Europe and Japan are still facing the slowdown blues. Therefore, if the demand continues to remain weak, what explains the 42% surge in S&P's GSCI, an index of global commodity prices? If New York Times is to be believed, the answer could be found alongside China's coast. At last count, atleast 90 large freighters full of iron ore were cooling their heels along China's ports, awaiting their turn to unload as the country's port storage facilities appear to be overflowing. And iron ore is not the only commodity that the dragon nation is splurging on, others like aluminium, nickel, copper, zinc and tin are also being shipped into the country in huge quantities.

Although the reasons each of these commodities are being imported vary, the end result is the same, higher prices of commodities in the global markets, as denoted by the S&P index. This has led many to believe that the current rally in commodities does not have strong legs after all and is likely to peter out soon. The Baltic Exchange Dry Index, one of the best leading indicators of international trade in commodities, has fallen by 20% in the past one week and also seems to be pointing towards the fact that the rally is indeed driven by Chinese stockpiling and may not continue for long. Central banks around the world can breathe easy. Inflation after all may not raise its ugly head in the near term. The long term though could be a completely different story.

Between 2003 and 2007 when the global economy was firing all cylinders and assets were not quite on the cheap, there was a flurry of M&A activity by Indian auto component players. Thus, when recession singed developed economies and similar assets became dirt cheap, one would have expected the M&A activity to get even more intense. But that is not the case. On the contrary, overseas acquisitions by Indian auto ancillary companies have come to a virtual standstill. If views of industry experts in a leading daily are considered, lack of funding from foreign banks and very poor capacity utilization at overseas plants are cited to be the main reasons behind the lack of interest. Consequently, most of their energy is being diverted towards saving their existing businesses from going down under. This, they are doing by looking at Indian banks for fund raising and undertaking some very strong restructuring measures.

The Indian markets closed marginally lower today led by losses in the BSE IT (down 3%) and BSE Oil & Gas (down 2%) indices. On the global front, while the Asian indices closed mixed, the European indices are trading in the green currently.

 Today's investing mantra
"Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down." - Warren Buffett

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3 Responses to "Has the Sensex run out of steam?"


Jun 13, 2009

This is the first time I have been able to find an excellent empirical reference linking economic fundamentals, GDP, to the Sensex. Based on Equimaster's model, I now observe and convey that the effect of rate of growth of electricity consumption is the real key and a correlated metric for GDP growth. Here is what Dr Anil Kakodkar, Chairman Atomic Energy Commission has said about this very vital linkage at the IAE Conference in Paris in June 2005:

“……Energy is the engine for growth. It multiplies human labour and increases productivity in agriculture, industry as well as in services. To sustain growth rate in economy, energy supply has to grow in tandem….”

Indeed Sensex coupled to Electricity Installed Capacity Growth Rate could be a truer representation of market reality in India. Perhaps your 5-Minute Wrap Up might spread awareness about this key index to the business community and its leaders in India and I suggest potential solutions to accelerate market growth as follows:

1. From your Web Site: 10-12% GDP growth rate = 27% growth rate for companies = 12-13% returns on a CAGR basis.
2. From the Elasticity of Energy to GDP Growth: 10-12% GDP growth rate = 8-9.6% electricity capacity buildup growth rate
3. From Authentic Sources India’s actual electricity capacity growth rate in 2008-09= 2.4%
4. 2.4% electricity growth rate = 2.4 to 3% GDP growth rate
5. Hence Returns on a CAGR basis= 2.5 to 3.9%
6. The most optimistic returns on a CAGR basis from the Sensex might be 5% and India companies growth rate will be restricted to about 11% per annum
7. Last year South Africa declared an Energy Emergency” as its critical industries were not receiving adequate electricity.
8. Perhaps it is time for Business Leaders in India to being this to Government of India’s notice. India is not fond of the word “Emergency.
9. The truth is that the electricity powerplant capacity infrastructure build up is experiencing a 68% shortfall in achieving planned targets. Government’s 11th Five Year Plan target is 11,000 MW per year (from all sources, coal, nuclear and hydroelectricity); actual achievement is 3543MW in 2008-09.
10. Finance to build up power sector infrastructure is not the problem. Nor is re-rating the Sensex going to address the fundamentals of this problem!
11. Industrial management in India is the problem. Centralized direction & control from New Delhi is not serving the purpose of achieving powerplant capacity build-up targets, as admitted by the Planning Commission itself!
12. Potential Solutions Some elements of a quick and effective solution:
a. With a single change in the Railways Ministry, Lalu Prasad Yadav, the entire railway system in India was transformed. Surely government and industry can find another Lalu Prasad to take over the Power Ministry?
b. Merge the Ministry of Renewable Energy Resources with the Power Ministry so that the constraint of ‘silo-mentality” is removed and the Power Sector is transformed into large scale applications of renewable energy
c. Expanding & new public and private industries need to be supported with massive investments from government and FDI encouraged in a big way for wind and solar power.
d. Only 30% of r electric power requirements for expansion of existing industries or creating new industries should be met with existing coal/nuclear/hydro electric sources. The industries should be encouraged by incentives to find the remaining 70% of their power needs by themselves. This is an immediate requirement



Vilas Havanur

Jun 11, 2009

Quite an informative article as always received from Equitymaster.


Dinker Rao

Jun 11, 2009

"Value investing is a life-long process, you buy little or nothing when the stocks have run up but you buy much when the stocks when the market is down but the business model is still a good idea. you will be wealthy if you keep it this simple" Dinker Rao

please include this quote from an Unknown indian

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