Are these signs of the stock market heating up? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Are these signs of the stock market heating up? 

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In this issue:
» Infosys kicks off the results season
» This important economic indicator has gone to its lowest in nine months
» China, the largest gold holding nation
» S&P: India's creditworthiness depends on reforms
» and more....

In every market rally, there should come a time when one takes a step back and gauges the broader picture. And when the craze continues for longer periods, the question 'Are the markets heating up?' would pop up in one's head.

Some of the traditional indicators of the same include crazy valuations and unrealistic long term growth expectations. Then there are the subtle clues such as stocks being the main topic of discussion at dinner and cocktail parties.

Then, there are clues that one could take from the foreign institutional investors (FIIs). As indicated in an article by the Mint recently, the authors discussed about how the concentration of holdings has changed over time. And this seems to be the trend as and when the market valuations start moving up. At the bottom of the growth cycle in 2002, the top ten stocks formed almost two-thirds of the FII holdings in the country. By the end of 2007, the top 10 stocks formed only about 35% of their holdings. In other words, FIIs increased their exposure to many more stocks.

Coming to more recent times, the authors reports that the top ten holdings of FIIs in mid of 2013 formed about 50%; and that once growth rates pick up, this concentration could come down all the more.

Also, we believe that looking at the performance of smaller stocks as compared to their larger peers is a good indicator for "heating up" as well. Over the past six months, the BSE Mid Cap index is up by about 25%, while the BSE-Sensex is up by about 10%. On the other hand, the BSE Small Cap index has zoomed up by about 32% in this period.

As reported in the Economic Times today, mid & smallcap funds have outperformed large cap, large & midcap and multi-cap funds in each of the followings periods: six months, one year, three years and five years.

The BSE-Smallcap index trades at a very high P/E of about 85x at the moment. While this may seem absurdly high, the depressed earnings of the index (as a whole) should be considered. In comparison, the BSE-Sensex is trading at valuations in the high teens.

As indicated by the authors of the article mentioned above, the valuation of the MSCI Smallcap index - an index which is made up of about 146 stocks; making up approximately 14% of the free float-adjusted market capitalization of the India equity universe - is higher than that of the MSCI India Index. The latter covers the performance of large and mid cap segments of the Indian market. It has 69 constituents, which cover approximately 85% of the Indian equity universe.

Historically, the MSCI smallcap index has traded at a discount of about 20% of the latter - in terms of valuations. Presently, it is trading at a premium of about 20%.

While we seem to be nowhere close to a 'bubble' situation per se, particularly in terms of valuations, one thing that gets clear here is that the growth expectations seem to be very high; especially from the changes that the new government would bring in. While there is no doubt that the bottom up approach would be the best way to go about things, it would be advisable for investors to revisit their portfolios and their allocations, as the risk-reward ratio seems to be in favour of the former at the moment.

Is the outperformance of smallcap stocks a sign of equity markets heating up? Let us know in the Equitymaster Club or share your comments below.

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01:45  Chart of the day
India's energy deficient status is quite well known. We import majority of the crude to meet our energy requirements. However, what is saddening is that no progress has been made to make India self sufficient in its energy needs despite abundance of natural resources in our own Motherland. Take a look at today's chart. It reflects how India's import dependence to meet its energy needs is likely to increase. The import content of all the three resources namely oil, coal and natural gas will increase in FY17, when compared to levels that prevailed in FY11. Natural gas is likely to witness the highest increase of all the three resources. Deadlock over gas pricing and lack of investments in the oil & gas space has hindered the energy security of India.

No end in sight to India's energy woes

However, it seems that the government has recognized this issue. And has also taken steps that may boost investment in the sector. As an example, as per current regulations, there are some restrictions on the contractor over exploration in its own energy blocks, those where commercial discovery has been made and production has been started. This is because the Government does allow cost recovery on exploration activities in such blocks. This has hindered the exploration activity in the country. However, the government is planning to relax restrictions in these regards provided certain conditions are fulfilled. The move is likely to promote the investment in oil and gas space and boost India's energy security. However, it is just a proposal yet to be approved. While this is a step in the right direction, India needs a lot of reforms to meet its rising energy needs.

India's second largest software firm Infosys kicked off the fourth quarter results season today. The company reported a better than expected bottomline performance with net profit increasing by 4.1% QoQ. However, its topline continued to remain under pressure as sales were down 1.2% QoQ. The harsh weather conditions in the US in the first two months of the year had hampered sales of large retailers. This had led to temporary ramp downs in many software contracts. The retail segment contributes 15.5% of the company's revenues and this segment witnessed de-growth of 4.2% sequentially. The management has clarified that this particular issue is no longer a problem but it has impacted the growth momentum in the short term. Revenue growth can now be expected to pick up only towards the end of 2014.

The guidance for FY15 given out by the company is for 7-9% revenue growth in US dollar terms; but it must be stressed that this is on the conservative side. As the year progresses and the visibility of revenue improves, the guidance will be raised upwards. In the short term, Infosys continues to focus on cost containment measures. The company's focus on reducing its onsite work force has certainly helped to improve margins. Going forward, the margin performance will be less closely watched.

What do you think is the best practical economic indicator out there? Certainly not global GDP growth. It is well known how complex its calculation can be. Besides, tampering with the numbers also remains a strong possibility. Consequently our search for something more reliable and possibly free from rigging of any kind leads us to the famous Baltic Dry Index (BDI). The BDI is essentially a measure of the costs involved in shipping raw materials around the world. It is therefore a leading indicator on how the global demand for commodities and raw materials is shaping up.

So, what is the BDI saying these days? Well, the reading does not seem to be all that great. Apparently, the BDI has dropped for the fifteenth day in succession until yesterday and has gone to its lowest in nine months. This is not a good sign we believe. It could well mean that demand for basic raw materials is on the wane globally and this can thus lead to subdued economic activity. Of course, a lot more data need to be analysed before we come to some sort of conclusion. But this is an important development we reckon and macro observers could do well to probe it further.

That China is creating a war chest of sorts is no secret. And the dragon economy is certainly not wasting its gargantuan forex reserve only on industrial commodity reserves alone! According to Forbes Asia, China may well be on its way to becoming the largest holder of gold. It is a known fact that China is the world's largest gold producer. But, like Russia, China exports no gold. Over the last three years, its declared gold holdings have increased by some 1,284 tonnes.

This makes China's estimated gold holding around 2,338 tonnes - a figure that can allow China to win the coveted title of the world's largest gold holding nation. But the story does not end there. China imports massive amounts mainly via Hong Kong and Shanghai. Further, China's gold consumption increased by 41% over 2012 to 1,176 tonnes in 2013. Needless to say that the country is making adequate preparations to brace itself for a global currency crisis. What stands out like a sore thumb is that the Indian government cannot see the writing on the wall. And despite the prudent decision on the part of ordinary Indians to protect their portfolio with gold, the government is making every effort to dissuade it.

The much-awaited 2014 general elections are finally underway. In a month's time, we will know the outcome. You would agree that this has been one of India's most-hyped general elections. What will be the impact of this election on the Indian economy? As per a recent report by Standard and Poor's Ratings Services, the outcome of the elections will be an important determinant of India's economic well-being in the coming times. As we know, the country witnessed policy paralysis during the UPA regime. Many key economic reforms that could have helped revive India's economic growth engine, remained in a state of limbo. The new government that is likely to come to power next month will have to show its ability and willingness to hasten up economic reforms. It is not so important which political party or parties come to power but what policies they pursue. But if there are too many political parties involved in forming the coalition government, then initiating policy reforms will be quite an uphill task.

In the meanwhile, the Indian stock markets continued to trade in the red. At the time of writing, the benchmark BSE-Sensex was down by 125 points (-0.6%). Most of the sectoral indices were trading negative with stocks from realty and metal being the major losers. Only IT and capital goods stocks were trading in the positive territory. Most of the major Asian stock markets were trading in the green led by Singapore and Japan. However, market indices in China and Hong Kong were down sharply. Most of the European markets have opened the day on a mixed note

04:55  Today's investing mantra
"We are searching for operations that we believe are virtually certain to possess enormous competitive strength ten or twenty years from now. A fast-changing industry environment may offer the chance for huge wins, but it precludes the certainty we seek." - Warren Buffett
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