The Rout – What Now?

A few days ago, Larry Williams made a poignant statement

“There is no technical indicator that will call the top based on what little I know about the markets I’ve never found one that can do that.”

Markets after being bullish for so long a time that people forgot that it can also go down once in a way gave way in dramatic fashion post the day of the budget. While the convenient excuse is that the break down was due to introduction of Long Term Capital Gains tax, the fact remains that re-introduction of a tax that has been talked about for quite some time now cannot be enough reason.

To me, the bigger reason is Valuation and the Trigger is not LTCG  but Political Uncertainty. Both these factors are enough to damage long term trend but not enough to erase all the gains that have been accrued so far.

This evening I was having a discussion on markets with my good friend, Vijay Sambrani who believes that given the way markets have acted around the 100 EMA in recent times, that would be a good number to watch out for trend reversal.

The chart above is the plot of Nifty 50 with the blue line being indicative of the 100 EMA. 2017 was one of the few years where this would have been a fabulous signal to watch for trend reversal. It currently stands at 10,390 which would require a fall of 370 points before it gets tested.

Markets have been on a roll for quite a long time now. Not since 1990 had we seen a year where markets hadn’t closed below the budget day close for a single day. In 2016 and one again in 2017, we saw markets not closing below the Budget day close for a single day. A kind of record for the ages.

While we Indian’s can blame our government for the correction, a similar strong dip was seen in the US of A. This is a cause of concern since like the Indian Markets, US market too has seen a near 45 Degree slope of rise in markets with very little volatility.

Is this the End

While literally everyone was waiting for a dip to buy as long as the trend was up,the moment it has started down, the question being asked is whether the trend has reversed for good and would be it better to exit completely rather than add to existing position.

In US as in India, Treasury Bond yields are inching up and this will have a impact on the bottom line of companies, especially those that have a overhang of Debt. It also serves as a warning that the market is anticipating a upswing in Inflation which is once again negative.

While yesterday’s fall was huge, from valuation perspective it has barely made a scratch on the surface, let alone a dent as it usually does.

The last proper correction in the Indian Markets started in March 2015 with the final lows seen only in February 2016. While the drop was one of a long duration, the depth wasn’t with the markets dropping just 23% from its peak. Compare this to the fast and furious crash we saw in January 2008 when markets dipped 30% in a span of two weeks.

Corrections are healthy in the sense they remove a lot of dead wood from the market letting it get ready for the next stage. But they are painful for as investors, seeing our wealth vanish day in and day out isn’t a pretty sight no matter if we know that this is temporary and in the long run, our wealth will grow back as markets rebound.

Between 1962 and 1965, the Dow Jones Index nearly doubled in value. This rally was not a one off as markets had steadily climbed from 1942 on-wards and while there were regular doses of correction, the trend of the markets had more or less remained bullish.

10x from the starting point, the markets though finally ground to a halt. Unlike in 2008 when markets crashed in no time at all, this was a slow motion act. While Markets went down and went up over periods of time, it never really breached significantly the highs of 1966. The final break above the high of 1973 (a 4% higher top above the high of 1966) came in late 1982 – a full 16 years from the first major peak.

Indian markets too have seen long period of literal numbness in markets. Take the peak of 1992 – the Harshad Mehta peak. It wasn’t breached 2004 though we did see it being broken in the fag end of the Ketan Parekh peak of 2000. The 2008 to 2014 range is well known.

On the other hand, we have had (in the Dow for instance) crashes like the 1987. It came in the middle of a strong bull rally and while the cut was sharp and deep, markets recovered and moved well above the 1987 peak in early 1991.

From a middle class perspective, the Budget was one of disappointment, investors in markets got skittled by the 10% LTCG that has been re-introduced. Businessmen were literally hauled through the rocks as Demonetization and later the implementation of GST had a impact.

The short term negative impact of GST were well known and given how our skills at execution, it was not much of a surprise to see it being done in a lackadaisical fashion. But the key thing is that this is now done. Another year or so, GST will have ironed out all the issues that currently hamper trade and a few years from today, we shall wonder how we could do business without GST.

World markets are a different animal. After years of easy money, the lightest indication of a reversal in that strategy is sending chill waves throughout the bond world.

Crude Oil which post the Shale Oil episode was never seen as something that will trouble anyone has nearly doubled since the lows of January 2016.

Valuations as measured by Trailing 4 Quarter Standalone earnings did not reach anywhere close to where it went in 2008 or even 2011. While the attraction to the mean is high, that would require a fall of around 26% from here (assuming growth is flat). Not a one day affair but not unlikely either.

 

Last year saw massive influx of investor money into Mutual Funds as other investing options started to under-perform. Many were drawn by the short term returns that have been generated by funds and will see stress when markets start to react. But not all will run for other options to invest aren’t anyway better than earlier which would mean a lot of money would stay.

A bigger concern would be in Arbitrage funds – these funds which had the tax advantage of Equity while behaving like Debt has lost that Arbitage with the introduction of the 10% tax on Dividends and Capital Gains. Post this move, it makes little sense to stay in those funds for why take a higher risk for returns that are closer to Debt (though they are still a bit tax advantaged).

With 60 thousand Crores under their kitty, we should see some pressure coming in as they will start to cut down their positions in market. Even assuming they come out of just 50% of their positions, that would require absorption of 30 thousand Crores of Delivery. Arbitrage funds being Long Stock, Short Stock on Futures don’t suffer regardless of the movement of the underlying given that they are fully hedged.

What to do Now

Its all easy to talk about the great opportunities one missed out in hindsight, but when the real opportunity comes, there are plenty of reasons not to take the very trade that may in the future seem as an attractive proposition.

No one can say for sure how deep the current draw-down will be before the reversal starts. Until 2008, a 30% drop over a period of 6 months was a usual phenomenon. This changed post the crash of 2008 with the new drops ending around the 20% barrier.

With Fed unwinding its Balance Sheet, it wouldn’t take a Genius to figure out that things may not be the same again. Currently Nifty 50 is just 4% from its all time high and yet we are seeing nearly 50% of stocks trading below their 200 day EMA’s.

The broad market divergence could mean that this is just getting started. Or on the other hand, stocks can go down much lower before we end this round of bearishness.

Lets compare for example, the percentage fall from peaks for stocks currently versus what they had witnessed at the end of the Bear run in 2012

By the time, the bear market got over, a lot of stocks had seen draw-downs from peak of 35 – 55%, a huge difference from the current falls of between 15 – 25%. In other words, there could be a lot more pain if this markets starts to become bearish going further.

The Asset Allocation Model as of end January remains unchanged and while it would start climbing up slowly as market becomes cheaper (due to either fall in the Index or better earnings growth or a combination of the two).

My view is that what we will witness in the Indian Markets will be the equivalent of the 1987 crash in the US. Once the dust settles, this would be seen a opportunity that shouldn’t have been missed. Political Certainty or not, the current reforms will have a impact that will be seen over the next few years regardless of who is in the driving seat. No point getting biased and missing out on yet another opportunity.