Preparing for the fall

The Nifty is at some 27 times trailing earnings (don't trust forward earnings estimates, which seem to be forecasted linearly). We already have a sense that the projected earnings growth of 20 per cent is not going to meet expectations for even the first year, let alone the three years of compounded 20 per cent growth that is built into expectations just now.

Here's how the arithmetic goes. At 27 times trailing earnings, Rs 100 of current earnings (last four quarters) is available at Rs 2,700. Now the long term valuation of a steady market is that it should be valued at the nominal rate of growth (of the economy). This is on the steady state (equilibrium) assumption that corporate profits as a percentage of GDP will stay the same. This ignores the cyclicality of corporate profits (as a percentage of GDP), which follow the waxing and waning of capacity utilisation, the stage of the capex cycle (i.e., leveraging or deleveraging), etc.

Without going into the details of the various scenarios, let's say that the nominal growth of the Indian economy is 7 per cent (real growth). Add to it 5 per cent inflation and you get 12 per cent nominal growth. With some small increases coming from the tightening capacity utilisation, you can assume that the existing 3 per cent of GDP that corporates earn will go up somewhat. Hence, you can expect earnings growth of 15 per cent over the foreseeable future.

Frankly, that is what the markets seem to have said on an average for a very long time. So, for these markets to be valued reasonably, earnings must rise 80 per cent, i.e., 2,700/15 = 180, against the indexed base earnings of 100. That's a CAGR of 20 per cent for the next three years.

This may be a fair assumption in certain cyclical plays (metals, maybe industrials, for example), but I can't see it happening in, let's say, IT or banking, which are seeing 1 per cent revenue growth and 5 to 6 per cent credit growth, respectively. If these expectations are belied, where should the markets be? The most conservative estimate would be 12 per cent growth at 15 times earnings, an indexed value of 1,680 compared to the current 2,700 (which is 62.22 per cent), close to the Fibonacci bottom (61 per cent) of a bear market if it were to start today. That means, for those who can't follow this train of thought, the market is worth 7,200, about 62.22 per cent of the current Nifty of 10,800. That's close to the last bear market bottom. The actual bear market bottom may be slightly higher because actual earnings growth may come in a little higher than my conservative 12 per cent, and some patient holders may be discounting two years of forward growth. In a hardening interest rate environment, I can't see it getting better than that.

This is also just when the interest rate cycle has definitively turned. Inflation is up, from the 'death of inflation' projections of 1 to 2 per cent to an out of the comfort zone of 5 to 6 per cent, warranting at least a small hike to communicate the turn of events to the market.

Worldwide, the negative interest rate policy (NIRP) regimes are ending everywhere, which is going to somewhat harden the cost of capital. The hardening may not be painful or steep enough to trigger material deleveraging, but it should stop the frenzied bull markets across the world. The Bitcoin (and other cryptocurrencies) blowouts prove that sanity will return to pricing in money markets. Nothing about mass human behaviour is ever orderly, but this might be the year when some of us will start using our logical brains.

I can't believe that crowds can process events (the turn of the interest rate cycle) so quickly after they have happened, so maybe this fact is in the process of getting absorbed into markets. I have been clearly telling everyone to leave equities and start building hedges in currency/commodities (like gold/silver), waiting for the lemmings to run off the cliff. The actual top may be some months away. (Disclaimer: Through my writing years, I have been consistently wrong in my timing, sometimes by up to two to three years. Mostly, it is because I see things, and talk about them, too early. From the first kid who says that the king has no clothes to the time that the whole crowd is saying it, the process can sometimes take quite a few months. Just don't try to time this.)

'Markets can be irrational longer than you can stay solvent', so don't take any naked positions that are looking for a crash. But hedged positions, like buying dollars against a bond portfolio, would be a good way to short the market.

Does that mean that you should be selling everything and putting your money under a mattress. Well, new money, perhaps yes, but large chunks of the market are a hold but not a sell. Will it be orderly? No, because I don't like how people have become sanguine that they can't see the end of the bull market (who can?), but they can see a correction.

Gold is a good place to hide. So is currency. Bet on a reversal in the US dollar index and some moderate dollar strength but don't bet on a reversal in euro/pound, which will stabilise somewhere here. The obvious place to hide is short term bonds or bank FDs.

A possible scenario is that there is no material price decline but a long 'time correction', which exhausts any but the most patient long term investors. Don't make the mistake of counting on domestic flows to shore up the exit of foreign money. The rise in capacity utilisation and some moderate pick up in private investment demand might be two jokers in the pack, which might give some uptick to our assumptions of actual earnings growth taken above. This will be patchy, affecting some sectors more than others. It won't be enough to shore up the entire market and the major indices.

So, what does the ordinary, lazy investor do? In the genuine, long term compounders, they should hold. Companies with enterprise value of six to ten times EBITDA and low to moderate debt should be held. Anything above that should be exited. If the ROCE is 15 per cent, you should be willing to pay about 1.25 times book and then push up your willing to pay price proportionately. If you apply these mathematical filters, you should be able to weed out the most expensive segments of the market.

Lastly, the "Warren Buffett ratio" of market cap to GDP is also in the danger zone. If cyclical profits as a percentage of GDP double, the current valuations will hold. That would require some tightening of the demand-supply balance. Given the low credit growth, any real growth in demand will add to the pricing power in the corporate sector but so would you see an impact on manufacturing inflation, which could bring an immediate impact on monetary policy. Those sectors with a material slack in capacity utilisation might see an uptick in their fortunes, so some stock specific stories will see a big change. But the composition of the market is skewed in favour of financials and defensives, so it will not be a secular spread of wealth across the market.

If inflation is the one constant in all the scenarios, it makes sense to buy that. In the short run, it makes sense to stick with short duration bonds or simple FDs. And in the long run, shift to long duration bonds, once real interest rates shift downwards. Specific stocks that give you an earnings yield above the bond yield should be held. That's actually a pretty large part of the market.