Thursday, November 3, 2011

The must know fact about economy-markets disconnect - Equitymaster.com

The first check point in predicting the direction of equity markets is to analyse the broader prospects of the economy. It is no secret that the economy, be it domestic or global, has the most direct impact on stock markets as well as other asset classes. Every economic cycle in the past has seen a similar trough and rise in equity markets. In fact there are several studies that show how closely economic variables, consumer confidence and equity prices are correlated.


However, veteran investor Marc Faber has made a very interesting observation in his latest Gloom Boom and Doom report that conflicts this basic principle. Faber agrees that economic and stock market cycles have moved in tandem in the past. But he makes a case for them not being so closely linked in the future. The reason being the concentration of wealth, and liquidity if you will, in the hands of a few. Faber argues that despite poor economic fundamentals in the developed markets, equity and other asset classes may not suffer too much. The premise of this argument is that since the 1980s, wealth inequity has increased significantly. According to him, currently the top 1% percent of households in developed economies earns 20% of all incomes. Also they own 33.4% of the total net worth of these economies. Hence, even though consumer sentiment is controlled by 80% of the population, just 1% of the population controls the money supply and fiscal deficits. The latter in turn largely determine the value of assets and exchange rates. With economic uncertainties like lower income growth and unemployment not impacting the moneyed class too much going forward, Faber believes that equity investing may remain unaffected.


While the logic of Faber's comment cannot be sidelined, we believe that his observation about economy and markets getting disconnected is a theoretical misnomer. For even the 1% population does get affected by the poor sentiment amongst 80% of the population. And when that happens, money supply deserts risky asset classes likes stocks and chases safe returns. At such times most rich households too prefer to maintain their wealth in cash or safe and liquid assets. Hence income inequality may be a reality in developed and developing markets alike. But neither can remain insulated from the downsides of economic cycles by the virtue of wealth concentration.


Do you agree with Marc Faber's views on economy and stock markets getting disconnected? Share your comments or post them on our Facebook page.


While an economic downturn threatens to hurt demand, sectors like cement and textile that have installed new capacities over the past few years may be the worst hit. As per data from Mint, the cement sector may see severe pricing pressure over the next 4 years due to over capacity. The fact that economic downturn will dampen utilization levels for a prolonged period will also hurt realizations. Thus the prospects of the cement sector stocks may remain subdued in the medium term.


 
Ice hockey is hardly a familiar sport in India but it will pay to heed the advice of a famous player in the sport, Wayne Gretzky. On being asked the recipe for his success in the sport, he commented that he skates to where the puck is going to be, not to where it has been. An extremely intelligent remark, it has widespread implications for investing too. Just like ice hockey and its puck, it is extremely important to choose asset classes or stocks that have a very good chance of going up and not the ones that have already gone up. This is the very same reason that perhaps led the famous investor Wilbur Ross to sound a bullish tone on Japanese equities. "Now is the time to invest in Japanese companies because not only are they cheap, they also serve as a great conduit for investing in emerging markets", he is believed to have said.


While an average investor in India may not be able to invest in Japan, he will do his returns a world of good if he takes the hidden message in Ross' comment to heart. He simply has to look for sectors or companies that are out of favour right now and invest in the strongest companies in that sector. The infrastructure sector is the one that comes to mind right now. There could be others too. The idea is load up on cheap stocks and have the patience to grind it out for some time. There is a very strong chance that one may get market beating returns.


In a popular book of Anthony Jay, (author of Yes Minister!), he made a pun at the politicians by saying the law of relevance is - 'The less you intend to do about something, the more you have to keep talking about it'. This seems to be exactly what the Indian government is doing. They keep talking about our fiscal deficit and how it is growing, etc, etc. But they are really not doing much to bring it under control. The latest thing to add to deficit woes is the military modernization plan. The plan is expected to cost roughly Rs 640 bn. It is required to combat the ever expanding threat of Chinese military along the Indo-China border. True national safety is of extreme importance.


But then what about the millions and billions that we have already spent on defense? Defense accounts for a large part of the budget expenditure each year. But by the looks of it, it has not been sufficient. Maybe it would have been better had the government planned its expenditure in a better way. Spending more on populist policies instead of on national security seems to have been its top priority till now. And as a result, it now needs to spend this outrageous amount to revamp the military operations. Well so much for bringing the fiscal deficit under control!


If not regulated well, people tend to behave like zombies. At least, the Indian life insurance industry seems to prove the point. To give you a brief background of the story, when the life insurance mania in India peaked some years back there were about 3 m insurance agents. Compare that with 1.5 m employed by the Indian railways and you'll figure what a massive number that is. But what's wrong with that, you may argue. Well, if you ponder a bit and wonder what possibly could have inspired so many people to flock into the insurance selling business, the answer would come out loud: huge commissions. The story of the life insurance industry unfolded in such a way that insurance firms paid inappropriate agents to sell inappropriate policies to inappropriate customers, and then penalised those customers in order to pay the agents.


Of course, the hysteria couldn't go on forever. The financial crisis of 2007-08 struck. Barring Life Insurance Corporation (LIC), the industry made a cumulative pre-tax loss of about US$ 4 bn up until March 2010. It was only then that the insurance regulators stepped in. Since then, the commissions paid to agents have fallen and so have the number of agents. So far in the current financial year, sales of new policies are down by almost 20% year-on-year. No doubt that India is a very big market for insurance and is set to grow. But the firms will have to take their steps prudently and patiently.


There was a time when many Indians harboured ambitions of securing better prospects in the developed world especially the US. So much so that brain drain became a concern for India. But many years later that scenario has completely reversed and so India is set to witness what is now being termed as 'reverse brain drain.' In fact this already began when the global financial crisis deepened. With the US and Europe mired in a recession they are not able to come out of, strong growth prospects in India have lured non-resident Indians (NRIs) to shift base here. Thus, about 300,000 Indian professionals employed overseas may return to the country by 2015, according to a recent report by US based Kelly Services. Indeed, the top three reasons for reverse migration between 2008 and 2011 were job insecurity, personal growth opportunities in India and the call of the native land.


Given that India has grown at a faster pace than the developed world and is expected to do so in the coming years as well have led to many overseas Indians to look for better opportunities back home. Rising compensation levels has also been another attraction. But all may not be hunky dory. The big question is whether Indians who have stayed abroad for more than 10 years will be able to adjust to the quality of life here. Also, there is no guarantee that all will be able to bag good jobs in companies given that there is so much competition from resident Indians as well. Whatever be the case, a trend has certainly been set in motion.


After a negative start, the indices in Indian stock markets managed to make inroads into the positive territory backed by buying interest in commodity and power stocks. At the time of writing, the BSE Sensex was trading higher by 65 points. Stocks from the auto, banking and telecom sector, however, failed to garner investor interest. Other key Asian markets are trading a mixed bag while Europe has opened on a positive note.


"Interestingly, we have beaten the market quite handsomely over this time frame, although beating the market has never been our objective. Rather, we have consistently tried not to lose money and, in doing so, have not only protected on the downside but also outperformed on the upside." - Seth Klarman


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