India's most prudent Regulator is preparing for a crash!

Aug 7, 2014

In this issue:
» Another proof that US stocks are bound to see a crash
» Europe's third largest economy slips into recession!
» Cognizant expects slower growth in IT industry
» Can Sensex earnings treble in half a decade?
» ...and more!

Last week, we had discussed about how the overheated asset prices in developed countries could potentially be a risk to Indian stocks, given the rising correlation of Indian and US stocks. We also discussed about how investors should not ignore the warning signs of some of the respected names in the industry.

Today, we have another name to add to the list. That is of Raghuram Rajan, Governor of India's central bank, the RBI. As discussed in the Economic Times, Mr. Rajan is of the view that global markets are at a risk of a market crash! And the reason for the same? Investors exiting the market at the same time.

That emerging markets are vulnerable to big shifts in capital flows - which have been brought in by money printing activity by central banks of developed nations - is a view that Mr. Rajan has been holding for a while now.

Over time, the RBI has taken many measures to curb the stress that could arise from occurrence of such an event. These include the attempts of curbing the current account deficit as well as the building up of forex reserves. Also, with the government's focus on keeping the fiscal deficit under control as well as make the various attempts to improve the inflation situation, all these steps would strengthen the overall economy, which is a key measure to curb volatility.

Also, while inflation has been showing signs of cooling down, the RBI continues to keep interest rates unchanged. The rationale behind this is to not go in for inflation fighting attempts at regular intervals, which is why it would be important to focus on strengthening all aspects of the economy.

Not only would all these steps help towards stabilizing the situation back home, but would also attract a good amount of investments from abroad as a stable economy would be an attractive entry point for foreign investors.

Nevertheless... while the RBI has been making attempts to manage the risks that could arise due to the overheated situation across the world, the key question here is how well placed are you as an investor?

Given the market situation in some of the developed countries, it seems the probability of the scenario getting ugly once the trends in interest rates and access to cheap liquidity reverse, is quite high. But when that will happen is anyone's guess. And we believe it should not be an area of focus for you as well. But as mentioned by Mr. Rajan "Anytime the US sneezes, emerging markets across the world catch cold". In our view, the best step that a long term investors should take now is to be well prepared for it.

"Predicting rain doesn't count; building arks does. " is a quote by Warren Buffett that we thought would be apt for this situation.

We believe it would be a good idea to make the most of the optimism surrounding the markets at the moment; hold on to the long term winners and exit those companies that you would have never touched during times of maximum uncertainty.

In other words, hold on to the best stocks, and exit the worst...

How should investors go about preparing for the possible market decline? Let us know in the Equitymaster Club or share your comments below.

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It is not Raghuram Rajan alone who's warning of an impending market crash. Guys over at a popular finance portal, also seem to be making a similar case. And a pretty data intensive one at that! If one were to plot the US stock market index's levels over the last 140 years or so on a inflation-adjusted regression line, then the current market appears nearly 86% above the trend line. To put things in perspective, the great crash of 1929 happened when the markets were 81% above the same trend line. In other words, if history is anything to go by, we could well be staring at another strong crash. This is not all. The same article argues how current measures of valuations, sentiments, leverage and complacency have all reached historic extremes. Of course there will always be bulls that would support the current rally. They would argue that this time it is different simply because of the record low interest rates and strong corporate profitability. However, we are of the view that the best way to invest is to take care of the downside first. And with the risk reward ratio not in an investor's favour, his best bet would certainly be to lower exposure to equities dramatically.

All is still not well with Europe if what is happening in Italy is anything to go by. As reported in Moneynews, Italy, the Eurozone's third largest economy, has slipped into recession for two consecutive quarters now. While the economy shrank by 0.1% in the Jan-March quarter, it was worse in the subsequent quarter when the economy slipped 0.2%. Recession is defined as two consecutive quarters of contraction of GDP. Eurozone typically sets a budget deficit target of 3% of GDP for all member countries and it could be a daunting task for Italy to stay within this limit. This is not the first time that Italy is facing a crisis. Indeed, in 2011 as well economic conditions had deteriorated considerably in the country threatening the wellbeing of the Euro region. A crisis of this sort once again brings to the fore the problems plaguing the Eurozone. The European Central Bank has been bailing out weaker countries such as Greece, Spain, Italy, Portugal, among others. But so far none of these measures appear to have worked as these economies continue to struggle. We will hardly be surprised if the current situation in Italy will be dealt with in the same manner as in the previous crises: more stimulus measures by the central bank.

 Chart of the day
Leading Indian IT companies have declared their results for the June 2014 quarter. As we had expected, the performance was a mixed bag. While TCS clearly led the way, Infosys lagged behind. It is quite clear that the performances of Indian IT firms are moving in different directions. The landscape is quite challenging. With discretionary IT spending showing muted growth across the world, winning large deals has become increasingly tough. These firms have to innovate to stay ahead of the competition. Thus pressure on the topline can be expected to sustain.

Indian IT: Growth rates to come down?
* - IT services revenue

In this regard, Cognizant has also scaled down its growth expectations for the year from 16.5% to 15%. It is important to note that even the original 16.5% forecast was below expectations when it was announced in February. Thus we believe that investors should be selective when it comes to IT stocks. In 2013, all stocks from this sector had a great run. However, this is unlikely to continue. Companies which are able to manage the changes the industry best will be the ones to outperform going forward.

Will earnings of India's top companies triple in the next 5 years? Well that may be a possibility if the economic growth, inflation, capital investments and input costs all move in a direction that is extremely favourable. Here we also need to also assume that there are no external macroeconomic headwinds and the government gives a free hand to the PSUs to deliver the best. However we recently came across a projection put forth by Reliance Capital Asset Management that the 3x growth in India Inc's earnings over 5 years could be a reality. The reasons envisaged are fall in borrowing costs and growth in sales. Well, while both could happen to an extent, assuming that fall in interest outgo will boost profits by 300% is a long shot according to us. The growth in sales will have to be accompanied by significant rise in operating margins for companies to multiply bottom lines. For that companies need to have adequate pricing power, incremental capacities and infrastructure support. Not to mention the availability of key resources at viable prices, especially for commodity linked PSUs. Without these, betting big on fall in borrowing costs to see EPS (earnings per share) multiplication will be like living in fool's paradise for investors.

In recent periods, Indian banking sector has been in news for wrong reasons. The two titanic defaults of Kingfisher Airlines and Deccan Chronicle have made history in the books of Indian banking industry. These two companies together have exposure of over Rs 120 bn. The lenders had spent sleepless nights recovering their money through the sale of physical assets or by invoking guarantees of these companies. But these names are just the tip of the iceberg. The list is longer than we can comprehend. Bad loans continue to loom large! Awakening to this harsh reality, the banking and the market regulator have joined hands and vowed to eliminate such dodgy activities. Forget about resolving bad loans in the system. The regulators have decided to nip the bad loan problem in the bud. Meaning they have planned to ensure that willful loan defaulters are totally shut out from any kind of funding. And not just banking funds, but they would be barred from raising market funds too.

Not to mention, the high growth phase did witness the unscrupulous lending and unwarranted funding to blue chip companies. Also, the banking system had fallen prey to the dubious promoters who managed to dupe banks of thousands of crores of rupees. The recent Syndicate Bank incident is the case in point. So the latest measures from the Reserve Bank of India suggest that the Governor is now keen to rid the banking system of practices that have eroded its health. Such amendments would go a long way in addressing the endemic problems in the Indian economy, we reckon.

The Indian stock markets continued to trade weak in the afternoon trading session. At the time of writing, the BSE-Sensex was trading lower by 96 points (-0.4%). Barring oil & gas and metal, all sectoral indices were trading in the red. IT and pharma stocks were witnessing maximum selling pressures. Majority of the Asian markets were trading weak with China and Hong Kong leading the losses. However Japan was trading positive. European markets also opened the day on a negative note.

 Today's investing mantra
"The whole concept of dividing it up into 'value' and 'growth' strikes me as twaddle. It's convenient for a bunch of pension fund consultants to get fees prattling about and a way for one advisor to distinguish himself from another. But, to me, all intelligent investing is value investing" - Charlie Munger

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2 Responses to "India's most prudent Regulator is preparing for a crash!"

H K Prakash

Aug 7, 2014

Exit all stocks at NF 8300 (next predicted high)? Switch to gold ETF/ coins. Sit quiet. Wait for crash ... bottom. Exit gold. Re-enter stocks! (Easier said than done)


Parin Thacker

Aug 7, 2014

Does that means it is risky to invest in small and midcap now? I have a plan to hold some portfoio in this segment, with a hope that new government shall mobilize industrial activities.

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