Sandeep Sabharwal - ‘Markets can fall by 10-20% from peak’

Usually a diehard optimist, Mr Sandip Sabharwal, CEO - PMS, Prabhudas Lilladher Markets, sounds a note of caution about the stock markets after their breathless rally over the past three months. Markets have not been so overbought technically for a very long time and such a state will not last too long, he says. Even while expecting a 10-20 per cent correction from the peak, he feels that India’s valuations will continue to remain at elevated levels, given the improved growth prospects for the economy.

Excerpts from the interview:

Have the Indian markets run up way ahead of companies’ fundamentals, especially in sectors such as realty, cement and infrastructure? The pace and ferocity of the recent rally in the stock markets is unprecedented. If one looks at a market like India, the key indices have all nearly doubled in a period of just around 13 weeks.

This run-up has come on the back of beaten down valuations, extreme pessimism and short positions in the markets, huge cash on the sidelines, improving liquidity, reducing interest rates and a bottoming of economic performance globally. The weakness in the US Dollar combined with low short-term interest rates has made the “Dollar Carry Trade” gain momentum.

If we go back to the year 2003 when the last rally started, it took the markets nearly one year to double from the bottom. The same thing has happened in just three months this time. However as a counterpoint, markets also never sold off the way they did in the year 2008. Since the fall was so sudden and sharp, the initial rally had to be sudden and sharp.

The key is that the speed of the rally has made everyone too complacent and has led to a phenomenon of panic buying in the markets.

Lot of the stocks in the above mentioned sectors have clearly run ahead of fundamentals although the prospects for cement still look positive. Valuations have moved up due to improving growth prospects and growth in the economy is likely to be strong at least for the next five years. Under the circumstances valuations will continue to remain at elevated levels over the next few quarters.

Should investors wait for a correction now to start buying?

Markets look overbought in the short run and should see some correction. I believe it is important today to stick to fundamentals and not to be carried away with the market momentum.

As we sit to evaluate what should be the course of action going forward it is important to recollect a number of data points that have come out over the last few days:

- Global trade continues to be in doldrums and both exports and imports of most countries are still in a severe downturn.

- Most large economies continue to contract and there are no signs of economic revival anywhere in the West. It is just that the pace of fall has slowed down.

- The valuations of most markets have clearly run ahead of fundamentals with most emerging markets now trading in the range of 15-17 times 2010 earnings, up from 7-10 times in the beginning of March 2009.

- The fiscal deficit projections of most governments worldwide are continuously moving up with slowing tax collections and higher spending.

- Cash on the sidelines has come down very sharply over the last two to three weeks as most institutions, especially mutual funds and FIIs whose portfolios are declared at the end of every month rushed to deploy a large part of their cash holdings so that their month end portfolio does not show huge cash throughout the rally .

- Inflows into emerging market funds which were running at over a billion dollars a week have now slowed down drastically over the last two weeks. As such a combination of low cash and low inflows should be a near-term negative.

- Markets have not been so overbought technically for a very long time and such overbought conditions will not last too long and will ultimately lead to a big sell off. The overbought nature of the markets at this point in time is similar to the markets prior to the fall in May 2006 when the markets fell off sharply before recovering in the latter part of the year. It is also similar to February 2008 when emerging markets were most oversold than ever in history.

- Government bond yields have firmed up globally over the last few weeks, driven by fears of huge borrowings and high fiscal deficits. The rise in these bond yields will make interest rate declines more difficult and may lead to interest rates stabilising at levels higher than what they should have given the global economic outlook and low inflation prevailing currently. Reducing Libor and corporate bond spreads have hidden this phenomenon in the near term, however this is something that need to be watched out

- If one includes the QIP issuances announced till date combined with the IPO pipeline, nearly $10 billion is proposed to be raised from the markets over the next one year. This is a huge supply of paper which can not only reduce the pace of market up move but also stop it at its heel.

Markets, as they start their correction, can fall by 10-20 per cent from the peak.

Mid-caps have once again caught the fancy of investors. Have the concerns about the companies abated?

The fear of insolvency or defaults in mid-cap companies has significantly reduced today. Moreover prior to the elections, most investors were unwilling to invest into mid-caps as they were not sure whether they could move out if things turned adverse. Subsequently, as investors became convinced over the long term direction of the markets, mid-caps have come back into the investment radar. Improved liquidity and reducing interest rates will now benefit mid-caps more than large caps. A vast majority of mid-caps fell by nearly 70-80 per cent in the bear market and have now bounced back to 30-50 per cent of their peak values on a broad basis. I believe that given the growth prospects of the Indian economy there are lot of quality mid-cap companies which will not only go back to their earlier highs but also move higher up. As such, any corrective moves in the market will provide a good opportunity to build up positions in high quality mid-cap companies.

Growth-oriented stocks will continue to get a greater premium over the next few weeks and months as investors become more convinced that the economy is clearly on the path of recovery. As such, long-term investors should prefer growth over value.

There have been contradicting signals on the commodity recovery story. What is your view on commodities?

More than 50 per cent of the global economy is unlikely to see much growth over the next five years and as such demand pressures will be low. This will result in commodity prices remaining suppressed (not withstanding the current rally backed by dollar weakness and expectations of economic recovery). Moreover the capacity expansion over the last few years have led to an overcapacity in lot of commodity industries which is unlikely to correct in the near term. Under the circumstances, I do not expect commodity prices to rally significantly over the next two to three years and would be more or less range bound.

via BL