When stocks defy fundamentals

May 6, 2009

In this issue:
» Slowdown in India for another two years?
» Jim Rogers keeps away from gold
» Working capital still expensive
» Bernanke expects a rebound this year
» ...and more!

Fundamentals don't seem to be driving stock markets over the past few weeks simply because the fundamental issues have not yet gone away. The world continues to fight a financial crisis, economies are in doldrums, policymakers remain confused as to what will be their next step and industries are going slow on expansion given that they remain unsure about the demand environment.

But stocks continue to run, and run fast! And apart from the large caps, even the mid and small cap stocks have seen their prices skyrocket over a period of just about eight weeks. The BSE-Midcap index, for instance, has run up almost 43% since hitting its lows in early March this year. And then, there are several stocks that have run up by almost 70-80% and a few have even doubled during this timeframe.

Without playing Cassandra, we would advise you to stay away from irrational exuberance. While quality companies in the mid cap space continue to trade at significant discounts to their actual worth, it would not be advisable to buy into such stocks just because you get a feeling of having lost out on the rally of the past few weeks. Unlike large caps, where there is no dearth of information, for mid-cap stocks, you need to put in more efforts while doing your homework, as we are doing ourselves by identifying solid mid-cap opportunities for long term investors.

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Despite the RBI's incessant attempts to moderate interest rates in favour of economic activity in the country, a Business Standard report throws some light on quite an unfortunate trend. The cost of working capital for Indian companies has anything but come down. Banks continue to be reluctant to pass on the benefit of reduction in the key rates. As a result, companies continue to borrow much of their working capital at 12.25%, which is SBI's prime lending rate (PLR). If India has to get back to a higher trajectory of GDP growth anytime soon, it's high time that banks loosen their purse strings.

The ongoing economic slowdown has obviously had some sort of an adverse impact on India Inc. But what do Indian companies have to say when it comes to forming an outlook for the future? According to a survey conducted by Ernst & Young and published in Business Standard, India Inc. expects the ongoing slowdown to continue for the next two years. However, despite this grim outlook, many corporate houses are confident of achieving at least 10% growth in this fiscal. What corporates can predict with some semblance of certainty is their own performance over which they have control, whereas predicting macro-economic factors especially those which are beyond their control are best left alone. The survey has further revealed that 42% of the respondents are of the opinion that they would achieve 90% of their targets in FY09, while 43% were looking at meeting 70-90% of their targets. Against this bleak landscape of economic turmoil, the display of confidence by corporates certainly lends some much needed comfort.

"The U.S. is printing money right now, and it's going to lead to a devaluation of our assets - we will demand protection." The odds that you would be able to guess the nation behind this quote are quite high. There aren't many countries in the world right now that are able to lock horns with USA in matters financial. And if you still haven't guessed it, allow us to spill the beans. It is China indeed. The dragon nation is the largest investor in US treasuries and hence, erosion in their prices ends up hurting China's interests. The above quote came from one of the representatives of the dragon nation at a recent gathering of Asia's top leaders and corporate chieftains.

China was also upset about the fact that despite having one of the world's largest economies, it did not have enough voting rights at important institutions like IMF and World Bank. Indeed, at US$ 4.2 trillion, its rights are equal to that of Canada, a nation with a much smaller economy. It wants to raise its stake to at least 8%, a number that is still less than half of the US but greater than countries from Western Europe and Japan. However, the task is not going to be easy. Experts reckon that although the country has achieved a lot in recent times, it still has a long way to go. As one of them put it, "It may have to deal with domestic worries before demanding a change on the global scale".

Whatever may be the outlook on gold in the present scenario, commodity guru Jim Rogers is not buying any gold currently. A Bloomberg report highlights his concern that some institutional gold reserves may be sold. Says Rogers "I own some gold, but I am not buying at the moment because the IMF, which is one of the largest owners of gold in the world, is desperate to sell its gold. If and when they sell their gold, they may set a bottom. Who knows? It may go down to US$ 700. They got a lot of gold to sell. If it does, I hope I'm brave enough and smart enough to buy more." However, he has also indicated that he is not looking at selling the gold he already owns either.

A sanguine US Federal Reserve chairman Ben Bernanke has said that consumer sentiment, the housing market and spending have begun to show signs of life, and that the US economy is stabilising and will begin to rebound later this year. However, he expects that the economy will continue to shed jobs and credit too will remain tight for some time. Business and household spending is expected to be slow to bounce back.

All in all, Bernanke expects economic activity to bottom out, then to turn up later this year as the economic contraction moderates considerably in the near term with businesses looking to replace their liquidated inventories. Given how central bankers in the US and other western countries have misinterpreted the crisis and have been deceptive about the reality, we would advise you to take Bernanke's words with a pinch of salt.

Even though other measures by the US government may find endorsement by Warren Buffett, he has been highly critical of the modus operandi adopted by the authorities for the stress tests of 19 large US banks. Buffett has said that they fail to properly assess the industry's health, and that he would buy more shares in three big banks Berkshire Hathaway already owns. His business partner Charlie Munger added that this one-size-fits-all reasoning in the case of bank stress tests is very likely to be done poorly.

Nevertheless, one thing that will clearly resonate with everyone across the world is Buffett's message - "The most important lesson is that the world needs a whole lot less leverage."

Robert Shiller, Yale University professor and author of the book 'Irrational Exuberance' famous for predicting the bursting of the tech bubble in 2000, has said that investors should brave the risk of economic chaos and buy stocks and real estate. As per a Bloomberg report, the Standard & Poor's 500 Index trades at 13.9 times its companies' annual profits, up from a 24-year low of 10.1 in March, after the index has rallied 33% since March 9, 2009. Shiller opines "The price-earnings ratio is about average, and by that you might say it sounds like one should be in the market and have a balanced portfolio that has a good share of stocks. Having a good fraction of your portfolio in stocks, not zero, is probably sensible now."

Profit booking at higher levels led the indices to lose ground during the final hour of trade. The benchmark BSE-Sensex ended the day down by about 1.5%. Stocks from the mid-cap and small-cap space too ended the day on a weak note, their indices lower by 1% and 0.2% respectively. Selling activity was witnessed in stocks across sectors, led by realty and banking. Power stocks, however, ended the day on a marginally in the green. Most of the other Asian markets ended the day on a firm note.

 Today's investing mantra
"A public-opinion poll is no substitute for thought" - Warren Buffett

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