AMC Speak

US market looking lot more vulnerable than ours

Anup Maheshwari, CIO Equity, DSP BlackRock

21st August 2017

In a nutshell

Corporate profits to GDP in India is at a 14 year low (lowest since 2003); US ROEs are trending at all time highs. Market cap to GDP in India is nowhere close to its 2008 levels; its at the 2008 levels today in the US. PE multiples in both markets are above historical average - in India, on a highly supressed earnings denominator, in US, on a buoyant earnings denominator. Interest rates are set on a gradual increasing slope in the US, we are nowhere near a rate hike cycle in India. Put all these factors that Anup lists together, and you can see why he is confident that we are not anywhere close to putting a bull market top in India, but the same cannot be said about the US. A significant correction in US markets down the line will impact our market without doubt - but remembering the difference in fundamentals can give you perspective on why you should buy into an Indian correction.

WF: The surge in markets in CY17 followed by the current wobble are raising fears that we are close to putting a top to this bull cycle shortly. What is your 12-18 month view on markets from here on?

Anup: Its always difficult to call market tops and bottoms and we don't venture into that space. But what we do look at is evidence on key market parameters. So if you look at valuations, while on a PE basis, markets do look expensive, that's also because we are going through a very depressed earnings cycle. Since most conversations around market levels tend to compare against 2008, we looked at price-to-book now and then - which we think is a better way to get a sense of where we really are, because P/B eliminates cyclicality of earnings that comes into the P/E equation. So today, some 25% of listed companies continue to trade below book value whereas in 2008, that number was closer to 5%. On the other side of the spectrum, 17% of stocks today trade at above 3x book - which is similar to where we were in 2008. What this clearly demonstrates is that 2008 was a widespread bull market whereas this one is much narrower, with many pockets not yet participating in the rally. Today, we are at a 14 year low in terms of corporate profits to GDP, back in 2008, it was a high. Today, the probability of earnings trending up is very high, back in 2008, scope was very limited when earnings growth was already high.

Based on this evidence, one can't see a correction now of the magnitude we saw in 2008. That said, one can't predict short term corrections that may happen at any time. Markets in fact should be displaying more volatility than they presently are, and that has lulled some into complacency on near term prospects. Every year, one should expect volatility to the tune of 10-15% at least and one just has to sit through these phases.

So as we look at evidence today, we don't see markets looking extremely stretched. P/E is not the best metric to value a market that is experiencing cyclical lows in earnings. Yes, there are concerns around sustainability of bull runs in some global markets - and some developed markets are looking a little vulnerable - but we don't think the Indian market, on the basis of fundamentals, is close to putting a top to the cycle.

WF: You talked about global markets - many observers believe the US market is looking shaky and perhaps very close to a cycle top. Liquidity at the margin is reducing with QE unwinding, interest rates at the margin are increasing albeit gradually and PE multiples are at historic highs. US materially influences other markets as well - what's your take on US markets?

Anup: Sitting here, one can only take a long distance view on US markets. Some of the parameters that we see are not very comforting: ROEs are running at all time highs, P/E multiples are at cycle highs, market cap to GDP is back where it was in 2008 and interest rates will rise at some point. All of these don't paint a great picture on equity returns going forward. So if there is a global correction led by US, we will see an impact in our markets too. But the thing about global corrections is you never know when it might come and from where. And you can't really prepare in terms of portfolio strategy for something that is an imponderable. So you need to track events and react sensibly. That said, the emerging markets space is clearly looking less expensive compared to developed markets which have enjoyed a good run over the last 5 years.

WF: Should advisors who went tactically long on equity now take profits in client portfolios and revert to their strategic asset allocation levels? Is it, on the flip side, time to reduce equity allocation tactically from the strategic allocation levels?

Anup: That frankly depends on the time horizon you have in mind for your tactical allocations.

WF: Lets talk about an advisor who is asked to demonstrate portfolio performance on a Y-o-Y basis.

Anup: Frankly if you have a 1 year perspective, you shouldn't be in equity at all. Fact is 90% of the time you are better off doing nothing but remaining invested. Its only 10% of the time that a tactical allocation may be warranted when you see extreme valuations, either way. Overvaluation typically happens when an asset class has already delivered strong performance in recent years and prospects for continued strong performance appear challenging. Indian equity markets don't seem to be currently displaying that characteristic.

Then the other dimension is how you define capital at risk. If you can't handle a 10-15% correction, you should not be in equity markets. 10-15% correction in a year is par for the course - that's normal market volatility - which you should ideally just sit through without doing anything. Its only when you see prospects for a much sharper fall - of 25-30%, that you would want to tactically go underweight equity. At this point, I don't see that happening in India.

WF: Our WF Advisor Confidence Survey 2017 suggests sharply dropping confidence in midcap funds. Would you agree that its time to cut back on midcap fund allocations in client portfolios?

Anup: While at a broad market level we believe markets are not overvalued relative to growth prospects, clearly there are segments in the market which do appear stretched on valuations. Broadly, the deeper you go down the market cap curve, the more is the incidence of stretched valuations. Many mid and small cap companies are now valued perhaps much richer than you would expect at this stage of the cycle and are therefore a lot more vulnerable to growth challenges on the way. This makes their stock prices a lot more vulnerable to significant drawdowns - perhaps larger than the usual market volatility. So, if advisors are on balance cautious about allocation fresh money to midcap funds, I suppose it makes sense. If you are overallocated to mid and small cap funds, that's a space you may wish to align back to neutral weight from a tactical point of view.

WF: Earnings recovery forecasts have been getting continuously pushed forward for the last 2 years, on various counts. Are we living on hope or conviction on fundamentals catching up with markets?

Anup: We are in an environment today where corporate profits to GDP is at a 14 year low. The last time it was this low was in 2003. We are at a cyclical bottom on earnings. The three main contributors to low earnings growth momentum have been banks, industrials and commodities. Commodity players have already started coming back to mean growth rates, banks should follow next and then industrials. So in the next 2 years, you will see a good pickup in earnings growth - also because you have a very low base that's been created anyway. Interest rates are heading lower, balance sheets are getting cleaned up. So there's enough reason for conviction - not hope - that earnings will recover quite well from where we are today.

WF: In what ways are you guiding your equity team's portfolio strategy at a time when the challenge is to avoid froth and yet remain competitive in performance league tables?

Anup: We try to stay away from too much top down thinking and we avoid taking cash calls. Our funds are typically always 95-100% exposed to markets. These are times when you need to be a lot more bottom up focussed. We continually test our convictions on the earnings growth forecasts for the companies we own. As valuations rise and stocks don't appear cheap, you need to be a lot more confident about the earnings growth panning out the way you think it will - otherwise you lose on both counts - which is what we want to avoid. There's nothing more really that we try to do. Our funds operate on a true to label philosophy - so a midcap fund won't become a large cap fund because we see relative value there. Its all about testing and reiterating conviction in the stocks we own.

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