Ridham Desai, MD and Co-Head Equity, Morgan Stanley, said the markets have made lower tops and bottoms, which confirms that we are definitely in a bear market. "Price damage is the first indicator. Around 75% of the price correction is over in the current bear market. Fundamentals have also given way. A lot of stock market drivers are taking us further into the red. The bottom may lie around 10,500. So, the markets are likely to se more downside for the next six months."
He feels that valuations have come off. "Markets are trading around 14 times forward earnings. They are still not cheap. Valuations will get attractive around 10 times earnings."
According to Desai, the markets are seeing a bear market rally. "There can be an 20-40% upside in the markets, but investors should sell into it, as one will never know when bear market end. It can only be defined in hindsight."
The markets may not go though a prolonged sideways move like the one in the 1990s, he said.
For the markets to rise, Desai said, crude prices need to top out. "Consensus estimate for FY09 growth has come in at 20%, which needs to be revised downward. We see more pressure on EBIDTA margins and downward adjustments. However, earnings bottom is dependent on policy response to economic woes like inflation."
He feels that investors need to patient. "One will get good buying opportunities on corrections. Investors can buy in small amounts for in investment perspective of around 2-3 years. They need to look at price erosions and valuations, which is the most fundamental tool. Investors also need to put capital to work slowly. They will see better times to invest further."
Desai does not see the markets hitting new highs very soon. "We can go back to the old highs by July 2010. However, equities will still remain the best asset class with CAGR returns of around 20%."
On politics, he said that expectations on reforms increase around formation of new governments. "Elections are likely to happen in May 2009. By then, the bear market may be over."
Excerpts from CNBC-TV18’s exclusive interview with Ridham Desai:
Q: Is this a bear market?
A: Yes. It has just established that. We have had fallings, tops and bottoms, and had the market stay below the 200 DMA convincingly. I don’t think there should be any doubt about the fact that this is a bear market. That debate should be over by now. The next debate will be how long this is going to last. So, that’s the question to be answered now.
Q: What convinces you about the fact that this is completely a bear market? Is it the price damage or any other characteristics that you have seen?
A: Price damage is the early indicator. The next indicator would want be what’s happening to fundamentals. Until fundamentals slipped, we could always be sure that this is just a correction and a bull market. But the fundamentals have given way. So, we have seen a change in the outlook, earnings estimates, and bond yields. So, a lot of things that drive the stock markets are actually going in the wrong direction for the market.
Q: All bear markets are characterized by a fairly sharp bear market rallies, could one of those come about in the foreseeable future?
A: Yes, we can be in the midst of one. The market has dropped 45% in dollar terms since the start of the year. India is the worst performing market in the world. It lost 20% in June, which is some sort of capitulation. So, the last bull on the Street was probably giving up in June.
Valuations have come off and the market is now below 15 times earnings. It is now around 13 times. Those are consensus earnings estimates on which I have my reservations. It is around 14-15 times earnings. So, the valuations have come off.
Politics seems to have settled a bit. Therefore, we could be in a rally, which is a classic bear market rally. That means another 10-15% up and then you sell the rally because you get a lower bottom after that.
Q: How significant have the past bear market rallies been in their intensity? Have you mapped the past bear markets?
A: Bear market rallies can be 20 -40%. They can be quite strong. In the 90s we actually had bear market rallies that lasted for weeks and not days. So, they can be long and quite vicious in their upmove.
Q: Does it lull into feeling that the worst is over?
A: Generally they do. We had one in March and it gave a feeling that this was a bull market correction. It was only until April and May when the fundamentals started slipping that we could be reassured that this was a bear market and not a bull market correction.
Q: We have had six months of pain already. Have you done any preliminary work on how much longer it could last going by the history of the last few bear markets?
A: We are three-fourths done with the price. Typically, bear markets lose about 50% from the top. That is the average. So, we have had one in the early 90s, had one in the mid-90s, and then had one after the tech bubble. Each one of them produced a 50% correction. It lasted for varying lengths of time. The early 90s were the shortest ones. That came at a time when India’s fundamentals were actually surging. So, when we were opening up the economy there was a big surge in reforms. It was a very different type of bear market. It was very short lived.
Q: Was it 50% in dollar or rupee terms?
A: No, it was in rupee terms because the currency has evolved over time. So, with a 50% correction in rupee terms, this market has finished about 75% of that. We lost about 8,000 points from the top. If you measure 50% from the top, then we are looking at about 10,500 points. So, we are done with about 75% of price correction.
The bear market is six months old. It could last for another 6-12 months depending on how various scenarios pan out. So, there is at least another six months to go in terms of time. The early 90s bear market lasted for a short time for about 12 months. The next one was in the mid-90s and that lasted about 85 weeks. The one that came in the tech bubble era lasted for 110 weeks, which means it lasted for over two years.
I don’t think we are in that type of a situation. We are more like between the mid-90s and early 90s. We probably could be done in 6-12 months.
Q: How do you define the end of a bear market? Is it reclaiming all lost ground or is it just a resumption of the uptrend? When you say it will end in six-months, what does it mean exactly?
A: Actually this is all in hindsight, so we will not know when the bear market ends. We will only know it in hindsight. It is basically from the point that the market actually starts going up, starts establishing higher tops and bottoms, and then establishes a new high. I have defined that as a bull market and the lowest bottom of the previous market is the bear market bottom.
It is only in hindsight, as we will never know when this actually ends. We may have already seen the end. We will only know six-months later whether this has ended or not, whenever the new high is created for the next bull market, which could be several months from now. It may not happen in the next six-months, but it could be happening in the next 18-24 months. Only then, will we know that this bear market ended on so and so date.
Q: How will this finally play out? Will we have a V-shaped kind of a recovery because in the past bear markets you go through a big sideways grind before the market moves up? Do you think it is that likely this time around as well?
A: The interesting thing about this bear market has been that the pace of price fall has been the steepest ever. We have lost 1.3% on an average every week for the past 25-weeks. The average for the last three bear markets is 1.1%. To a lay observer there doesn’t seem to be much of a difference between 1.3% and 1.1%, but that is a 20% difference. This makes it really viscous and it feels like that. So, I am not surprised if somebody feels, ‘Oh God! This market is really hurting’. It is hurting and this is hurting more than it hurt in the tech bubble or in the mid-90s. This is all to do with the way information is absorbed these days. It is very different from the past. The Internet has evolved. It was still evolving in the early part of this decade and information really passes quickly. We will not go through that pre-longed phase that we went through particularly in the mid-90s when the market just went sideways for 4-5 years.
What we will get is probably a bottom, some consolidation, and then establish a new bull market which may not get one to the high very quickly. But it will feel much better than what we feel today.
Q: Forget about the 40% Sensex fall, many stocks have lost three-fourths of their market cap and these include many largecap names. Has it come as a surprise for somebody who is sceptical?
A: Yes. This whole thing about measuring the fall from the top is an incorrect way of looking at things. We have to see how much they have actually risen from the bottom, before we look at how much things have fallen from the top.
Even stuff that is down 80% from the top is still up 5 times from the bottom. These stocks had done extremely well. I was just looking at the universe of largecap names. These are not midcap and smallcap stocks that have fallen 60-70% year-to-date. They are up 20% YoY. So, if you bought them last June, you are still making money in these stocks, even though they have actually lost two-thirds or three-fourths of their price this year.
What we need to see is how much stocks have moved from the bottom rather than just looking at how much they have fallen from the top. What has happened in terms of falling from the top is basically taking away the fluff that got created between October and January when a lot of stocks tripled and quadrupled. It reminds me of Infosys in 1999 and how it actually doubled between December 1999 and February 2000, after it had already gone up 10 times before that. That is the type of price appreciation we saw at the end of last year. That explains why we have seen such a big correction this year.
Q: On what factors would this six or 12 months correction hinge?
A: There are few factors. What happens to commodity prices, essentially crude? How quickly does crude top out? The faster it rises the better it is for this market. You really don’t want crude to hang around there. You want it to be done and over with quickly.
It depends on how quickly consensus revises earnings. The consensus has been very stubborn about earnings. The outlook has worsened and analysts and companies need to come out and tell us that the earnings have slipped. As soon as that happens, prices will adjust quickly and we will come to the end of it.
Market valuations are middling in fair value territory. We want it to get undervalued. That’s how bear markets end. Markets get really cheap, but it is not that cheap. In March 2003, the market traded at 8 times earnings. I am not saying we are getting there, but this is still way above those levels. So, the market has to feel very cheap. Investors should feel like selling their house and buying equities. We don’t feel that way still.
Q: What is that level according to you?
A: I think 10 times earnings, which is better than what it was in March 2003. It has still a little bit to go from here.
Q: So, about 10,000 on the Sensex?
A: Maybe yes. That would be a screaming level. But we might not get there. We may bottom out around 11,000-11,500. That coincides with our view on 10-year bond yields, which is giving you a vicious upswing. It will probably cool off for a while because of the sheer pace at which it has risen. But we are probably toying with a double-digit 10-year bond yield. That is not good news for equity valuations.
Q: What changes with the 10-year yield?
A: It changes both the topline and bottomline of equity valuations. It hurts corporate revenue growth and profits. From a very fundamental perspective, it increases the rate in which you need to discount cash flows, and therefore it moves down P/E. So, if you plot the change in the P/E ratio versus bond yields on a chart, they are inversely correlated.
Q: Perfectly?
A: Yes, perfectly. When bond yields go up, the P/E ratio falls. If they are going to skirt the 10% zone, which is the highest that we have seen since the late 90s, then PE ratios could go all the way back to where they used to be. We have come from a very low interest rate environment and have become used to it. So, interest rates have been a kind of a shock. It takes time to get observed. So, we can look at bond markets and sense that. I don’t think that has happened yet.
The other factor is domestic capitulation, which hasn’t happened. Foreign investors have been selling through the past few months, but domestic investors keep buying. The net flows into domestic funds are still positive. Investors are still putting money into their insurance schemes and are still buying equities. They have taken away from the 2004 and 2006 corrections that it doesn’t make sense to sell into corrections, because then the markets come back and one is left out. Until these investors give up, you may see the markets actually hunting for a bottom.
Q: Do you think they will panic, is it just a question of threshold?
A: Yes. At some point in time, they will panic. We have seen a structural change in the way household investors are behaving. This has got a lot to do with the demographics in India. There is a younger population out there, which is willing to take more risk. It has also got to do with the income progression that has happened. There is a bit of a change. There are more products out there that protect capital and give you insurance. All these things obviously complicate matters. It would probably not be the same as it has been in the past, but we still need to see some slowdown in flows.
Q: What is your take on revising earnings downward? Even now, people are saying above 15% earnings are not too bad. So, what is so bad about it? Do you think that will have to break down or can earnings surprise?
A: That’s interesting. Consensus is still estimating a 15-20% growth for the current financial year. Analysts say the aggregate growth number this quarter for Sensex constituents is 5%.
This surprises me because we still have a 20% outlook for the year. We have only got 5% for this quarter, which will be the best quarter this year. So, it is only going to get worse from here.
So, consensus is taking too much time in revising earnings down. It is partly to do with the fact that the corporate sector is yet to adjust to this new environment, because they don’t see it actually. It is not that one has seen a complete collapse in revenues or operating profits. We are moving into a situation where operating leverage will hurt negatively, instead of positively. EBITDA margins are at all-time highs, so they will start coming off. One will see a sudden slip in profits.
It will take consensus a while to adjust to that. It is not surprising. If you go back in time, the consensus usually starts with a 20% forecast on earnings. Then, it adjusts according to how the quarters behave. In the last five years, we have adjusted upwards. For the next one-year, we will adjust downwards.
Q: Do you think if Q2 and Q3 are bad and we arrive at the end of the calendar with two bad quarters of earnings, then it will be the darkest point at which people give up and say, ‘We got it wrong, now earnings has finished, and we will start bottoming out there or could it prolong into next year as well’.
A: The policy response to inflation will matter. If inflation doesn’t cool off, then we will see more rate hikes and therefore a further slowdown in growth. The risk at this point seems biased to the downside. The fundamentals would take longer to bottom out. But prices will be bottoming out much before that. Whether it happens in the next 6-12 months will be determined by how the macro behaves.
The macro may take 18 months to bottom. We may still get bad numbers from macros, even next year, but share prices may have seen their bottom before that.
Q: Is politics not one of the determining factors on when we are going to bottom out?
A: Actually the markets do well in elections on their own. That is what has happened in the last four elections. The rationale of the market applies. They hope that the next government will be a narrow coalition. Therefore, we will get more momentum on policy reform. Unfortunately, each of the subsequent governments in the last four elections has been coalitions. That has caused the market to sell-off post elections.
In terms of politics, I really don’t expect early elections. I think elections will happen next May. That is really a long time for us to really discuss, because then we are talking about the markets response in January or February. By that time the bear market may well be over. If elections produce a narrow coalition, then it may just mark the beginning of a new bull market.
Q: So, you do not buy right now as you expect another fall after any kind of a bear market rally? At what point do you start accumulating? Your portfolio has taken a very different stance in the last six months. When the bear market is about to end, do you change those bets and track different horses again?
A: The first is to go goose hunting. You may remember from Larry Livingstone’s book that sometimes you don’t want to do anything in the market, you just want to take a break.
Q: So, stay in cash?
A: Yes. One has to be patient with investing. Don’t be in a hurry. Bear markets produce incredible opportunities to buy strong franchises at attractive valuations. I think they are coming. We are already getting there with some businesses and franchises like real estate, and banks. Some of these stocks are beaten down beyond what their long-term value is. Their near-term earnings may remain under pressure. There may be some serious business risk in the near-term. Earnings may have to collapse, but these share prices may actually seem affordable to a long-term investor. A long-term investor is somebody who has a 2-3 year view to actually start buying stocks patiently. One buys little-by-little, accumulates, and then waits for the bull market to start. We are getting there. There are certain stocks and sectors which have become quite attractive and investors should take a serious look at those names.
Q: When you start buying do you change the bets from FMCG etc - the defensive kind of slant that you’ve had because it is a bear market to when the bear market is ending ‑ and try to get a little bit more aggressive?
A: It is a function of price erosion. We have not seen enough price erosion. How much has this stuff risen from the low. Financial stocks like banks and real estate are still up 600% from the lows even though they have all fallen 50% from the highs on an average. Some have fallen more than that. They need to still correct a bit. Ultimately, valuations are the most fundamental tool when one is making stock bets for the medium- or long-term. There are valuation metrics that you track. I believe in discounting cash flows and using my expected rate of returns. But one can use some steady metrics and decide this is what one wants to do. Then, one needs to be patient with it because bear markets do take stocks well below their fair value. So, stocks can become cheap. I don’t think one may want to give up at that point in time. Instead, one may want to buy more by putting your capital to work little by little. That time is not far away.
Q: What is your best guess of when the market reclaims its old high of 21,000?
A: Maybe in two years.
Q: So, what July 2010, will it take that long?
A: Yes, it is a 50% rise from current levels, which is still a very good return if you get that, because then it is a 20% compounded annual return. Which asset class is going to give you that return if the markets do go back to their old highs in July 2010? I think we would have generated 20% compounded annual return, which will be awesome.
Source: Money Control.com
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