Are the Markets in for a Perfect Storm?

"Eventually there is going to be a financial accident... something will break".

Those were the words in today's headlines by JP Morgan strategist, David Lebovitz.

Another classic headline echoed the same narrative... "10-year US treasury yields at 16 year high."

As inflation continues to remain high in the US and European countries, the problem only seems to be increasing.

It is always said that the bond markets are always right and precede the stock market when it comes to forecasting a big financial event.

After all the bond markets are larger and more evolved than the equity markets across the world.

If you look at all the parameters, right from VIX i.e. the volatility index, bond yields, dollar index (a safe haven asset), every possible indicator indicates stress in the global financial system.

Many investors heaved a sigh of relief when the US Fed decided to pause increasing rates.

However, little did they realise that the battle was only half won. The problem is not only rising interest rates but interest rates remaining this high for a long time.

High interest rates even if they are stagnant snowball into high cost of capital when combined with a slowdown could lead to catastrophe.

A fun fact is that majority of the young Americans have never in their lives experienced such high inflation or interest rates and have no idea of what is happening.

The last time USA saw such high interest rates was in 1970s.

We investors sitting in India must realise that even if USA sneezes, emerging market countries will catch a cold.

In the end, market movements are all about fund flows. A strong dollar is not what we want for the brightest economy in the world.

Now, as an investor there are 2-3 things you can do in this situation.

One is to stay put and let the expected storm pass.

I'm using the word expected as financial mishaps normally happen all of a sudden leading to contagion. It is extremely difficult to predict a 2008 like crisis.

The next question you will ask me, is that if there are so many indicators, why can't we predict a crisis?

Well, in 2008 too, the writing on the wall was always there. A lot of people had forecasted the 2008 crisis but the key is the timing.

As Jim Rogers puts it...

• "Every time I see a bubble, I enter it, only for it to become bigger so that I can make money out of the excess. The key is not overstaying your welcome".

The signs are there not only in the global market but also the Indian market in terms of excesses - read more about it here. The only question is, 'When'?

The answer is... I honestly don't know. But let me tell you what I know and what you can do to protect your portfolio.

It's prudent to take profits in average quality companies and sit on a bit of cash. The real problem lies in the fact that cash is one of the lowest yielding assets.

People in the stock markets, especially midcap and smallcap investors, are used to at least a 20% return on an annual basis.

7-8% pre-tax interest rates for stock market people is difficult to digest.

So, here's a 2-step solution to safeguard your money.

#1 - Sell your poor-quality stocks. The stocks which you bought by reading WhatsApp forwards in your family group or on a casual conversation with a friend or a relative.

#2 - The money you generate out of the sale proceeds should be deployed in decent quality stocks which are trading at real cheap valuations.

The reason I am not advocating to keep cash is we can't time a crash. Not me, not some financial genius, not JP Morgan... Nobody. The only thing we can do is prepare for a crash.

So, what do I mean when I say decent quality stocks trading at cheap valuations?

Well here are a couple of stocks which you should keep on your watchlist. These are not recommendations.

1. Aegis Logistics
   
   It’s India’s leading oil, gas, and chemical logistics co. It operates a network of bulk liquid handling terminals, liquefied petroleum gas (LPG) terminals, filling plants, pipelines, and LPG gas stations to deliver products and services.
   
   Basically, this company is a play on the LPG demand in the country. There is a massive deficit in domestic production and demand leading to higher imports.
   
   The LPG which is imported and comes via ports comes through the infrastructure of Aegis Logistics.
   
   The company over the past 3 years has been doing massive capex leading to pressure on financials.
   
   The interesting part is the valuation. The mean 5 years P/E ratio was 32x while currently it is trading at 24x.
   
   The stock has corrected by 21% from the peak at a time when small caps are on fire.
   
   If the markets fall, I believe the downside will be capped as valuations are cheap and earnings are likely to be strong.
   
   
2. UPL
   
   UPL is the 5th largest agro chemical company and 4th largest seed manufacturing company in the world.
   
   UPL derives more than 80% of its revenue from branded products but it is gradually moving away from being a generic post-patented agrochemical company to being a company offering differentiated and sustainable crop protection solutions and bio-solutions.
   
   The company’s operating performance has been declining over the past many quarters which is reflected in the stock price.
   
   The share price is down by 25% over the past one year.
   
   The interesting part is the valuation as well as the capital efficiency. The median 5-year P/B ratio is 2.5 times while currently the stock is available at 1.5x.

The point I am trying to make with these stocks is that when the market corrects, these stocks are likely to fall less compared to the overvalued midcap and smallcap stocks.

The margin of safety on account of valuations is the relative moat for these stocks.

While no one can predict the timing of the rain, it is imperative to keep an umbrella ready.

Warm regards,


Aditya Vora
Research Analyst, Hidden Treasure
Equitymaster Agora Research Private Limited (Research Analyst)