Friday, February 27, 2009

Buying “Undervalued” Stocks Part-3: Completing Sectoral Analysis


Buying "Undervalued" Stocks Part 1: Does it Work?

Buying "Undervalued" Stocks Part-2: Do Other Sectors Follow the Same Pattern?

So far, we have seen that the evidence in favour of buying undervalued stocks (when they are hammered versus the broader market) in hopes of a sharper bounce back is mixed at best and goes against observed behavior at worst. Today, I would like to complete the sectoral analysis so that we can move on to why this kind of biases, right or wrong, persist and their implications on market behavior and trading strategy.

IT Sector Index

The IT sector index does show some reversion to the market returns during the bullish phase. The index, by and large, outperformed the Sensex throughout the entire bull run and gave sub-Sensex level returns only towards the fag end of the bull run, as shown by the chart below.

During the bearish phase also, the index has outperformed the Sensex on a sustained basis. That means barring a few months at the fag end of the bull market, the index has maintained its outperformance over an extended period of time. This goes directly against the hypothesis we are trying to test.

There is another peculiar feature of these two charts. IT has now matured to an extent that it is now almost as good a "defensive" bet as healthcare or (as we shall see later) PSU stocks. In fact, it is better than pharma/healthcare because it has outperformed both during the bullish phase as well as the bearish phase. What it does to our hypothesis is a different matter of course.

Oil and Gas Index

To be objective, we should not be looking at Oil and Gas Index for comparisons because of the highly warped policy impact on the sector. Government policy for this sector is driven more by electoral considerations and less by economic sense. Still, for the sake of completing the comparison, am printing the charts below. Conclusions, if any, are again not supporting the hypothesis being tested and again there is no evidence that buying a beaten down sector or selling an exuberant sector is a good bet unless there is a change in the general nature of the market (i.e., from bearish to bullish or vice versa)

Bullish phase chart

Bearish phase chart

It is noteworthy that the index actually outperformed the Sensex in 2008 when oil prices were rising and Indian oil companies were under a tremendous amount of pressure due to lack of any clarity on the policy front. Other than that, please draw your own conclusions.

Power Index

This is a relatively new index and we do not have full history of the index extending to starting of the last bull phase of the market. But we do have significant amount of information pointing to the fact that the hypothesis is not directly supported. The bullish phase chart is reproduced below.

The sector did outperform right upto the end of the bullish phase. On the bearish side, the underperformance is still continuing on a sustained basis.

Though the data here is inconclusive, the returns of the sector are yet to get back to the Sensex level.

PSU Index

This one is my favorite, because it can allow for a lot of myth busting.

The PSU index was an underperformer throughout the bullish phase of the market, particularly in the latter half of the bull market. This underperformance, however, did not allow any investor to make any value picks "within" the bull market and anyone buying on relative underperformance would have continued to lose money right up till the end.

Furthermore, it highlights another factor (though unrelated to our discussion) regarding the policy folly of sinking significant taxpayer money in public enterprises where markets can do a better job. If the PSUs in general are going to underperform the broad market to the extent of 20-40% during very good times, exactly when are they going to create value?

The situation would be rescued a bit if PSUs were countercyclical and outperformed the market during bearish phases. But there too, things do not square up.

Here also, the PSU index has kept mainly in line with the Sensex, outperforming only for last two months of the analysis.

The broader point here is the relevance of the government staying in business of providing services that are much better provided by the private sector. As I said before, it is not pertinent to our discussion here, so I will not dwell upon it further. Suffice to say, the data again does not support the contention of buying "undervalued" stuff and the investor may not be rewarded even when the market sentiment changes completely.


Last, but not the least, the sector that sparked the entire debate.

We do not have full bullish phase data for the real estate sector. But that is also due to the fact that real estate got "hot" only towards the middle of the bullish phase and companies like DLF got listed a bit late in the market run-up. That said, the sector turned in a spectacular performance and outdid the main indices by a long shot.

The 4:1 outperformance is quite significant. The stocks, by any definition, were quite overvalued purely based on the returns generated by them. But anyone who sold or shorted the stocks at any time would have paid a heavy price.

The bearish phase data also paints a similar picture.

Once the sector lost favor of the investors, there was no stopping the slide in all key stocks. It has continued to underperform the broader market.

It is difficult to say whether the sector is going to reverse the slide once the broader market stabilizes a bit. Given the evidence from other sectors and earlier data available, it is quite unlikely. Unless we see the end of the bear market and beginning of another secular bull phase (something that is not in sight at the moment), investors in the sector are more likely to lose money than gain it back.


Considering all the sectoral evidence, it is clear that the contention of buying "undervalued" sectors during a bearish hammering may be more of a myth than reality. Some sectors like banking to exhibit a shorter cycle within a bullish or bearish market, but that may be due to the fact that banking is much more readily affected by monetary policy stance and as economy expands at a higher or lower rate and as central bank adjusts monetary policy and rates, etc.; the sector responds to those cues.

All the investors who have been thinking of making some easy money or a killing as they buy stocks that have been pounded into the ground may be in for a nasty surprise. The truth is, once a stock starts falling, there is no bottom for it. During the 1992 bullish phase, investors saw an Apollo Tyres falling for a high of Rs. 1600 to single digit levels. A decade later, the experience was repeated with Himachal Futuristic. I will not quote Satyam during the current phase because of a scandal influencing the market prices. But the point remains the same. If you buy a stock with a peak of Rs. 1000 on the way down at Rs. 500, there is no certainty that it will not fall to Rs. 50.

This truth eludes investors quite often as they indulge in what behavioral finance labels as Base Price fallacy. I will also add to it another notion that tanks investors quite frequently, that of reversion to the mean. The latter, in fact, is so rampant that it affects not only retail investors but is the nemesis of real pros as well.

We will continue this discussion in the remaining two parts of this series.

Rupee: The Move Begins?


I have maintained for some time that we are approaching the stage where the Reserve Bank of India will begin to slowly abandon its defense of the rupee. Though in my yesterday post Going for Broke, I had conceded the possibility of a protracted defense of the currency, but that goes against the policy stance as well as independence of RBI.

The writing has been quite clear on the wall for the rupee. The fundamentals have been aligned against the rupee for some time now and pressure has been rising. In this backdrop, it was unlikely that RBI would mount a long standing defense of a particular level. Going by the history, RBI generally likes to soften the blow instead of stubbornly blowing good money for defending a meaningless level.

Capital Flight?

It is important to note that FII flows have been generally negative since Satyam story breaking out, barring a few days in February. The recent change in outlook for India by S&P also creates pressure on debt flows as funds mandated to invest only in investment grade paper gear up to exit if a rating downgrade happens.

Clearly, capital flows will continue to be negative for quite some time for the rupee which has its own implications on the economy. I have argued time and again that foreign capital is key to Indian growth story as it helps to plug a long standing gap between savings and investments. But that story apart, the immediate impact is going to be on the rupee.

No Long Standing Defense

It is interesting to note that the massive defense of the rupee mounted by RBI during last quarter of 2008 was more of an exception rather than the rule. Highly negative global environment endangered the currency to the extent where a panic could have developed had the central bank not intervened.

I still maintained the view that RBI's defense of the currency lasted a bit too long, more than what the situation demanded. Afterall, a weaker currency would have helped the beleaguered export sector salvage some of the situation. But RBI is a conservative central bank and moves in a sure footed way rather than taking hasty decisions (we like RBI for being like that, though). But now the situation is clearly out of the panic mode and fundamentals have to take over at some stage.

Where Do We Go?

From here on, it is quite likely that RBI will let the deteriorating fundamentals reflect in the currency, though in a slow, delayed, lagged fashion. It also has to keep in mind the fact that a strong defense in face of worsening fundamentals just invites predators to profit at the cost of the central bank. The market will get where it has to get anyway.

On the technical side, a move beyond 51 is likely to take the rupee in the 53-54 zone over a month or two. This is probably the last chance to buy dollar cheap for any treasurer in India.

Thursday, February 26, 2009

Buying “Undervalued” Stocks Part-2: Do Other Sectors Follow the Same Pattern?


The first part of this article was published on Feb 4, 2009.

During the last discussion, we found that the hypothesis we are testing for was inconclusive based on analysis of auto sector and the banking sector. It warrants further testing with other sectors data to find out whether we can conclude either way.

Metal Sector

One of the hottest sectors in the past boom, the metal index is a good proxy for the active markets we had in equities in the last boom.

The bull market information, again, is not very clear. Whenever the sector reverted to the returns offered by the index during the bullish period, the index did bounce back. Yes, there is cyclicality in the returns versus the main index, there is no evidence still that the market could be traded based on the hypothesis of the sector being overvalued or undervalued.

The bear market graph is more insightful. If the earlier hypothesis was to hold out, the sector should have seen a fairly good bounceback by now, especially since the sector returns have tanked to half the level of general market. Still, there is no such bounceback in sight.

At best, this is weak evidence for the hypothesis. At the same time, it also allows the opposite conclusion that an outperforming sector during the bullish phase continues to outperform throughout the bullish phase. Likewise, a laggard in bearish phase is likely to continue being a laggard throughout the bearish phase.

Consumer Durables

Popular perception has been that the consumer durable sector was one of the laggards during the last boom. But the data does not support this contention. Contrary to perception, the sector was one of the outperformers during the latter phase of the bull market.

The first leg of the bullish market again supports the contention that a sector that is relatively undervalued versus the market tends to outperform later on. The earlier dip around February 2004 is followed by a relative peak in October 2005. But is there any evidence to follow up on that?

The answer to that seems to be no. The sector continued to outperform the broader market from February 2005 onwards right upto the end of the bull market. That is a long period of time and anyone banking on the overvalued theory would have lost a lot of money.

The bearish phase also brings out the same phenomenon. Once the sector started underperforming, the difference between the returns offered by the sector versus the broader market has been growing and there does not seem to be any respite.

This clearly indicates that during any cycle, it is quite possible that a sector can outperform the market for extended periods of time. In fact, in case of some sectors, we can even argue that it is more the norm than otherwise.

Capital Goods

Capital goods also exhibits exactly the same phenomenon. The fundamental reason for this is quite clear. During bullish years, investments are on an uptick giving a boost to the sector. The trend completely reverses during a downturn.

Or does it? What about all the additional spending by the governments on infrastructure and all? What about lower interest rates fueling demand? And overall economy also tends to shift to a lower growth. Then why should the sector not exhibit the same pattern of returns?

Anyway, the data is quite unmistakable on this count too. The fundamental logic apart, the outperformance or underperformance tends to last for almost the entire bullish or bearish phase. So here we go.

The bear phase also showcases the same situation.

Again, the sector does not follow any rules of reversal during the entire cycle of the market. During a particular phase, if it is outperforming, it continues to outperform during the entire market. During a bearish phase, underperformance tends to extend for quite some time.

Consumer Goods

The FMCG sector again follows the same pattern. The sector was a laggard during the entire bullish market of five years and anyone who bought on undervalued theory would have underperformed the market. At no point during the market move did the sector show any signs of improving against the broader indices.

The situation completely turned around during the bearish phase as strong underlying demand became a strong selling point for this sector and returns have been outperforming the main indices ever since January, 2008.

This sector too supports the hypothesis that an outperformer tends to stay an outperformer for an entire bullish or bearish phase and vice versa. Anyone taking the view of buying undervalued sectors or selling overvalued sectors would tend to lose out versus someone following the broader market alone.


The last sector being considered for this article today also follows the same broad pattern. I will not repeat the arguments. Will just reproduce the charts.

Bullish phase

Bearish phase


So far, we have not found any convincing evidence whether the hypothesis of buying undervalued stuff really works in the market. While the evidence in last article was mixed, the sectors examined today clearly point to the opposite direction; sectors that are outperforming or underperforming tend to continue to do so for an extended period of time.

We will continue to extend this analysis and wrap up the analysis part in the next post.

Going for Broke

The government seems to have made up its mind at last. After dithering for a long time on "stimulus" and hesitating in the face of a possible rating downgrade, there seems to be clarity on which way it is going to go. Hence, ahead lies more pain, more disenchantment and possibly a rude shock to growth aspirations of India.

The Fiscal Mess

The mess on the fisc is now complete. After a lot of hesitation, the government has decided to make a complete hash of the fiscal situation. The excise and service tax cuts are going to just widen the hole in the finances of the government. More than that, it is doubtful whether a service tax cut is going to do much to stimulate the economy. In fact, a waiver of the FBT would have been far more beneficial for the corporate sector than a cut in the service tax.

But the government has gone beyond that and seems to have decided that populism is the way to go. Hence, we may get another diesel price cut any time soon. This has nothing to do with economic logic, needs of the hour or sound governance. It means that petty electoral gains count much more than the future health of the economy.

Is a Downgrade Avoidable?

It was probably just a coincidence that the change in the economic outlook by S&P came side by side with the announcement of duty cuts. But the impact is not going to be lost. With these duty cuts, it seems that the government as well as the rating agencies have thrown in the towel and a downgrade is now imminent. If S&P's revision in outlook is followed up by duty cuts and populist squandering of resources, it means that both the rating agencies and the government must be preparing for an almost inevitable downgrade of the country's rating.

While earlier we were sitting on the borderline and were on the brink of a downgrade, the recent moves have raised the risks tremendously. It makes avoiding a downgrade fairly hard, if not impossible.

Going by the history and convention, the agencies typically wait for at least a month or two before making a downgrade after a revision in outlook. That means a downgrade can happen as early as March 31 for India. Which means that from April 1st, we are going to see a lame duck government, a country in deep fiscal mess and foreign money being pulled out amid worsening economic environment.

Impact of Downgrade

The primary impact of downgrade is going to be on gross capital flows, particularly on FII flows into debt. It is quite difficult to predict how the equity fund managers are going to view a rating cut, though in a generally deteriorating environment, the bias is going to be that of pulling money out. But on the debt side, it is far more certain. FIIs will have to pull out.

The reason behind that is legal and has nothing to do with the individual choice of the fund manager. Once a security loses its investment grade status, all the funds that are mandated to invest only in investment grade paper do not have a choice but to exit.

A certain portion of FII money, therefore, will have to pull out of India because of mandate and binding covenants, regardless of their view on the economy and the markets.

Rupee Blues

This is likely to put the rupee under a tremendous amount of pressure. Going by the recent moves on the policy front, it is likely that the currency will be defended well before the elections (though it goes contrary to independent policy stance followed by RBI). That will mean squandering forex reserves for chasing a worthless goal.

But there is more to it than just reduction in currency reserves. When governments fight the markets, the markets eventually win. I think the government thinking is pretty clear on this. They just want to hold the fort till the elections. Post that, the fight is likely to be abandoned. The markets will eventually win anyway. Hence, a painful adjustment process awaits us post the general elections.

The Way Out

A prolonged ride at the bottom seems to be in the offing. If the adjustment process in the economy begins somewhere around July/August instead of right now, it means a delay in the recovery plus a slower recovery as the excesses being created now also need to be cleared out. As of now, we do not know when global recovery is going to take place, but India cannot start regaining the growth trajectory before mid-2010 anyway.

Indian Growth Story

So far, the long term growth story for India has been intact. Even with the current moves, the fiscal deficit is far below the highs seen during mid-1990s. But a worsening banking sector, lowered tax revenues and need for deficit spending for infra sector may continue to put more pressure on the fisc. Moreover, all the excess borrowing by the government needs to be serviced and continuously high deficit leads to a much higher interest burden which can spiral out of control.

Quite clearly, this turn in the cycle has the potential to derail India's growth engine. If these excesses by the government are not reversed post elections and instead become medium term policy, we are seeing a possible step-down in India's growth potential and 7% growth may become a difficult target to achieve over next few years.

Friday, February 6, 2009

Currency Risk Rising


I have been writing for quite some time on the rising pressure on the rupee that has been held in check by the central bank till now. What we have seen over past two months has been a stable phase for the Indian economy with only one adverse event, Satyam, impacting the market. But this phase is likely to end pretty soon as event risks multiply disproportionately and different EM currencies start feeling the heat.

The assessment in terms of vulnerability has focused more on currencies like the Korean Won. The reasons have been simple. Bad currency hedges have put a lot of pressure on the exporters there, exposure to short term bank loans is high and roll overs are necessary to prevent a credit default and so on.

But, like all things that are… well unexpected…, this time the currency pressure starts from another source of randomness, the Russian Ruble. Russia is facing a huge risk of capital flight as people believe that a massive depreciation of the currency is on the cards (see Brad Setser's excellent piece on this). That in turn puts more pressure on the currency. Talk of a self-fulfilling prophecy!

But people do not have a right to complain when they have happily taken advantage of the self-feeding cycle on the upside. Now that the cycle is turning, everything that worked on the upside has to work on the downside. The most a central bank can do is try to soften the pain. Something that the Russian central bank attempted and has been "rewarded" with a downgrade.

Falling Like Ninepins

There is a good reason to believe that if Russia gets badly mauled during the current pressure on the currency, it puts all the EMs under a tremendous pressure. Slowly, but surely, the risk perception is going to rise and the next weakest link is likely to fall anytime soon. It means that any economy with

  1. A currency that is overvalued or is seen to be overvalued; or
  2. A big exposure to the external account; or
  3. A big debt obligation that is hard to roll over; or
  4. A very bad fiscal situation

is going to see a massive pressure on the downside on the currency.

This covers a fairly wide spectrum. The entire Eastern European (EE)sector is at risk, Korea is at risk and so is India.

Indian Situation

Post the Russian situation, I think things have undergone a fundamental change for the Rupee. One, it should have an impact on the willingness and commitment of the central bank to defend a particular level. So far, the Reserve Bank has defended 50 quite well, though it ended up throwing away $50 billion + of reserves in the process. Should the pressure mount again, I do not think this can be done again.

The second thing to watch out for is the "line in sand" level of reserves that the country needs to maintain. Sure, there is no fixed level, but there is still a fuzzy "line" beyond which the foreign currency rating becomes vulnerable. Can the central bank let the reserves fall indefinitely? Absolutely NOT! Particularly when we do not even know what the government's fiscal position is going to be like.

The Fisc and RBI's Role of the Rescuer

The entire problem is exacerbated by the poor data collection and archaic accounting practices of the government. It takes months for the government to find out whether it is seeing a positive or negative surprise. Under stable circumstances, it is inconsequential. Under current circumstances, it is critical.

As I have noted so many times, the central bank is the sole savior in the current crisis for India because the government never preserved any ammunition for the "real war". Honorable Ex-Finance Minister Mr. P Chidambaram fired everything that he could lay his hands on the moment he saw it. When you fire all your shots when you don't need to, you are left with nothing at the time of need. The fact that the post of Finance Minister has been left to languish speaks volumes about what the government thinks it can do to tackle the current crisis. To me it sounds like 'nothing'.

So RBI is the chosen firefighter for the moment. And there is a lot it has to do. Among them, compensate for the deteriorating fiscal situation that can spring a surprise at any moment. The fact that credible information is available with a long lag makes it very hard for RBI to calibrate the policy response properly. And it runs a significant risk of either undershooting or overshooting on the policy side, a situation that is wholly undesirable.

Why Aiming Right Matters

The case for this is quite straightforward. RBI cannot underdeliver on stimulus because the task of keeping the economy afloat is quite critical. On the other side, overshooting runs big risks. It could turn off international capital just at the time when we need it the most.

I have a high regard for the RBI's capability in managing it. And I do believe that they are going to be as cautious as they have been so far in managing the policy response. A lot of commentators have expressed different levels of frustration with their pace or the way the crisis is handled. But in hindsight, everyone agrees that RBI has gotten practically everything right.

This time around too, the cautious approach will continue and we are likely to see more and more unwillingness to defend a particular level of currency as the reserves fall. Let me enumerate why that is the case:

  1. Deteriorating fisc means rating pressure going higher on a continuous basis; if India has to avoid a currency downgrade, this requires maintaining "adequate" reserves.
  2. RBI spent about $50 billion in the last wave of currency defense. The assumption at that time would have been that it would get a chance to "refill" the reserves as soon as things "normalize". That is a remote possibility, to put it mildly, under the current circumstances.
  3. Capital flows have turned decidedly negative. This was not necessarily part of the equation of the earlier defense mounted by the central bank.
  4. Now the killer. Rupee is STILL overvalued on a long term basis despite such a massive correction. Any guesses on how the outside world is going to view an overvalued currency in a developing economy with a massive fiscal deficit and a massive trade deficit?

The resolve to hold a particular level is going to be markedly different if the next wave of bearishness hits the rupee.

Where Do We Go from Here

All the elements are aligning for the next wave of reality check for the Indian market. Slowing demand, slowing manufacturing, slowing real estate, stubbornly bearish stock market, negative outlook on the currency; these are the risks facing the economy. Is all of it going to materialize? Probably not. Only the most cynical and only career bears will believe in this scenario. But things are not very rosy either.

In my view, a "perfect storm", if it happens, is going to be shortlived. The most bearish scenario is applicable only when policy response is absent. At least on the monetary side, that is not the case. In all likelihood, RBI will choose to soften the blow instead of a stubborn defense, preserving valuable reserves. In all likelihood, RBI will focus more on injecting liquidity through QE instead of cosmetic interest rate cuts that do not work. In all likelihood, they will calibrate their response quite carefully instead of firing all their shots at the wrong time.

What we need to guard against, in the meantime, is a global event. It is the unforeseen risk at the moment that needs to be watched out for.

Thursday, February 5, 2009

Fitch Downgrade of Russia: Dangers of Being a Fiscal Gunslinger


Fitch downgraded Russia yesterday. This clearly brings out the dangers that India faces during the current downturn. Given the current state of the fisc, there is not much room to do a good stimulus package. In these times of uncertainty, doing nothing is not really an option either. But how much can be done and what impact will it have?

In my January 27 post, Monetary Policy Review: Why We Admire Reserve Bank of India So Much, I had touched upon why doing too much on the fiscal side is difficult (section titled "Bold" Advice). India is a developing economy and not a developed one. Hence, jacking up public debt (government borrowing) to above 100% of GDP levels is not an option at all. That is a luxury available to the likes of the US and Japan only.

Debt Trap and Fiscal Bloat

There is another reason why there needs to be a cap on the borrowing levels of government. Not many people today are aware that barely a decade back, Indian government was caught in something called a debt trap. If you read through the federal budget of any 1990s year, you would realize that the interest outgo on the government borrowing tended to be close to or more than 50% of total revenue receipts of the government.

This is the reason why there has been such a great emphasis on fiscal consolidation in the early years of this decade. The government runs a bloated affair. If 60-70% of your total revenue receipts are going to be eaten up by the cost of running the bureaucracy/government and your interest burden, where is the room for spending money on development?

More Burning Issues

But that is more a longer term issue and people in India do not necessarily care about it too much provided they get to keep their jobs and homes. The problem is that international agencies and investors may not share the same view. And too much aggressiveness on the fiscal side may bring a swift downgrade for India.

As I said in my earlier post, this is NOT AN OPTION for India. A downgrade at this stage is going to be a big negative, the proverbial straw to break the camel's back. We cannot afford it.

Painted in a Corner

Quite clearly, the rating action on Russia is going to make the government much more defensive than before in terms of fresh spending. The vote on account is going to be much more cautious than was likely earlier and hopes for any further meaningful action on the fiscal side should be abandoned quickly. Anybody banking on a fiscal package needs to reassess the assumptions of their investment hypothesis.

Market Action

Market action is unlikely to get affected immediately. But there is ONE NOTE OF CAUTION. Once the election guidelines kick in, the ability of the government to respond quickly to any negative newsflow is quite limited. All these constraints, whether they are on the fiscal deficit side, need to maintain reserves or the election code of conduct; mean that the ability to react is the lowest when the event risk is probably at the highest in the current bear market (for details, please see Event Risk Rising).

This enhances the risk of next breakout being on the downside considerably. Trade with caution.

Wednesday, February 4, 2009

Buying “Undervalued” Stocks Part 1: Does it Work?


Many times, you get advice from many market analysts on buying stocks that have been "beaten down". The reasoning applied is that when the market bounces back, these stocks will outperform the market. But does this strategy work? Or this is also one of those stock-in-trade phrases deployed by market analysts?

The premise on which such a piece of advice is based is that there is some fundamental value to a sector or stock that does not move around too much. If, therefore, prices move away too far from that, they are likely to revert to that fundamental value.

But does this approach work in the market? I have heard this particular set of advice so many times that I am tempted to test the validity of this assertion. Moreover, as we will explore in the later parts of the series, this kind of thinking is instrumental in creating one of the most enduring investor behaviours in the stock markets. There is certainly some value in exploring this. Either way, we can use the results to build a specific trading strategy around it.

Okay, the argument we want to test is the following:

If one of the sectors in the stock market is "beaten down" (which means it will underperform some benchmark index or indices in a significant way), it is an indication of undervaluation of the stock/sector. When the benchmark starts recovering, the sector is going to outperform the benchmark and will show higher percentage returns.

Since we are setting up a quasi-statistical test of this argument (sorry folks, complete statistical validity requires a lot of time and we do not have that), the other two aspects of this argument also need to be outlined and tested.

  1. The Corollary. The opposite of this argument should also hold true. Thus, if there is one sector giving a massive outperformance of the benchmark indices at a time, it can be termed "overvalued" and it should be possible to enhance returns by switching out of this sector or by shorting this sector and going long on the benchmark.
  2. Timescale. This needs to be shorter than the business cycle. Since the change in the business cycle alters the fundamentals of most of the sectors, any "turns" that happen after the cycle is over neither prove nor disprove the hypothesis we are testing.

At some stage, we will get into the intellectual merits of the argument as well, because there are important implications of that on the trading psychology side. But, before we get into the merits of the argument, we will go through some evidence whether it holds out against market data or not.

Let us take two time periods; May, 2003 – January, 2008 and January, 2008 – January, 2009. The first period was an out and out bull market. The second period has been an out and out bear market. This clear cut off allows us to test the hypothesis in a very neat and clean way.

Also, in terms of data, let us go by what is available in the market, so we will pick up some indices like Bankex, etc. and compare performance with Sensex. I am picking up BSE indices because there are quite a few sectoral indices available. Out of the total 10+ indices that BSE computes, I am picking up practically all the sectoral ones for analysis: Auto, Bankex, Metal, Consumer Durables, Capital Goods, FMCG, Healthcare, IT, Oil & Gas, Power, PSU and Realty.

We begin our analysis with the Auto sector, something that has not seen something of an outright bullish or bearish sentiment. Even during the downturn, there have been mixed trends in the sectors. While Bajaj Auto has underperformed, Hero Honda has outperformed and so on.

Auto Sector

Looking at the relative performance of the Auto Index and Sensex during the outright bull market, we see some possibility of making money by being relatively short vs. Sensex in case of auto index. But it is not very clear. Thus, when autos started outperforming Sensex in May, 2003; the trend continued right upto June, 2004. That is one FULL year of outperformance before some sort of moderation of performance happened.

On the other hand, the sector qualified for "beaten down" tag between Q1C06 and Q4C08. Anyone who got out of a broad portfolio consisting of Sensex stocks to get some "value picks" in auto sector would have either lost money or would have underperformed the market.

Moving on to the outright bearish phase, the auto sector relative performance looks like the following:

During the bearish phase of the market, there is some credence to the assertion that you can make some money when a sector is relative underperformer vs. the broader index. But here it is important to remember that the difference in performance is less than 5%. Hence, technically it does not qualify to be called overvalued or beaten down at any stage.

Banking Sector

The second index in our series is the Bankex. Here also, using the same methodology and taking relative movement vs. the Sensex, the following plot is obtained.

Looking at the Banking index, there seems to be some sort of "mean reversion". Of course, we are not arguing here on HOW to enter and exit positions that exploit the relative under or outperformance. We just want to know whether someone following this strategy can make some money.

Hence, in case of the banking sector, if you can find a way to pick the turning point in performance, it should be possible to make some extra money in the market. It is interesting to note that during mid – 05 and mid – 06, banking stocks were actually big underperformers despite a highly rosy economic scenario, demand for credit booming and good treasury income coming to banks. Still, the sector underperformed versus the broad index.

Looking at the bear phase graph, the evidence is a bit less convincing:

But still, the index does show some sort of reversion, meaning it outperformed the broad Sensex during Jun, 08 to Dec, 08.

Initial conclusion

So, our tests of first two indices do show a partial support for the view that you can trade an "undervalued" sector or an "overvalued" one. Whether this is a broad hypothesis or just a coincidence will be examined in the following parts of the series.


Event Risk Rising


By now, we know that most of the "regular" bad news has been factored in by the market. In that sense, we are approaching the middle of a bear market formation. This is the point from where on, the market is technically poised to test the earlier lows and then start moving in a sideways formation.

At the same time, the reverse impact of the stock market (termed "reflexivity" by Soros in his book The Alchemy of Finance) is probably the maximum at the time of bear market approaching its "half life". The reasons for this are quite clear. Due to lags in data etc., all the bad news is probably just getting out now. Which means that the investor confidence is probably at the bottom. It is interesting to note that all forms of scandals and sleazy news starts breaking out in the middle of a bear market and continues till the end.

During such a time, most of the businesses are going through a painful readjustment to a much lower level of economic activity. Some are affected more than the other. E.g., real estate has gone into a phase of complete drying up of sales. Inventory backlogs, high cost base, etc., on the other hand are still putting a lot of pressure on margins. The situation can be likened to a long, heavy train applying breaks suddenly but only on the engine. If the bogeys do not have breaks of their own, not only will the train slow down only with time, but the front will slow down while the real continues its momentum. This would put an enormous amount of strain on the middle.

Essentially, this is what happens in the middle of a bear cycle. This makes the next few months extremely stressful for the companies, till they adjust to lower business activity levels.

This raises the event risk associated with weak companies significantly. It is hard to predict what is going to break and what is not, but in terms of probability, something going belly up is much more likely over next three months than in subsequent one full year.

Trading strategy: it is wise to run a small, out of the money put options position over next three months.

Banking: When Will the Bad News Be Factored In?

Slowly, the market is becoming a bit more sensitive towards the likely problems to be faced by the banking sector in India. As always, this time too international investors a bit ahead of the curve. Hence, listening to Chetan Ahya was a bit illuminating.

The points he brought up were quite clear. Indian banking sector is quite well conversant with high NPAs, as high as 6%, the level last seen in mid to late 1990s. That is something which I feel quite worried about. The impact on bank balance sheets apart, it has a cascading effect on the economy as banks get extra cautious in lending. SME sector is the hardest hit under such circumstances as the flow of funding completely dries up.

I have long maintained the view that during coming few months, the credit crunch is going to get worse and only the top rung corporates will have access to money at reasonable rates. This does not bode well for the economy because big corporates account for only a small chunk of employment and SMEs are primary drivers of employment and consumption. A dent there will have a strong impact on any hopes of economic recovery.

Clearly, mere interest rate cuts and government directives to lend are not going to be of much use under such circumstances. One reason why bank credit freezes up so badly for small sector during crunch times is the poor recovery mechanism available to banks. Hence, one of the ways to free up bank credit market would be to make the recovery process faster, more robust and more transparent. Of course, it sounds more like a paradox and requires political will. Something that is hard to find at the moment. We are in an election year, so expecting such a "harsh" measure is wishful thinking.

On market side, I think there is still some time for the bad news to be fully factored in. At some stage, small and medium cap stocks will start seeing the effect of the massive credit crunch and will enter a completely sideways phase. Banking stocks, on the other hand, are likely to start feeling the heat from one to two quarters down the line. Hence, share price correction should come much earlier, may be around March. Clearly, going long on banking would require some caution under such circumstances.

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