2010 vs 2007

Key Debate:

Leading indices are approaching all-time peaks and very naturally investors are drawing comparisons with 2007. The market hit its all-time high in January 2008 before it plunged. Investors are worried the market may be heading the same way in 2011. What are the similarities or, more pertinently, the differences between 2007 and 2010?





Bottom line:
The market and the economy are not comparable to the exuberance of 2007 on most counts – even though the tail risks are still linked to global risk appetite and hence inflation or capital flows. Indeed, those risks panned out in 2008 – first inflation surged via higher crude oil prices and then capital flows vanished because of the financial crisis.



Our base case is that neither of these are likely to happen in 2011, given how different the world is today compared to 2007. To that extent, the market is likely to continue its upward march in 2011.



Reforms, infrastructure and real rates: The reform and infrastructure story appears much stronger in 2010. Stimulus may have played a greater role in growth in 2010, pushing demand ahead of supply andpartly contributing to higher inflation and external deficit. Real rates are in negative territory, whereas they were positive in 2007. Banking sector liquidity also appears much tighter now.



Capital flows: Even though gross capital flows appear strong in 2010, on a net basis, they do not come close to 2007 levels. Thanks to a wider current account deficit and less intervention by the Central Bank, accretion to foreign reserves in 2010 is a fraction of 2007’s. This is the case even as FDI matches 2007 levels and FII debt and equity flows remain materially higher.



Private capex cycle and funding: Corporate balance sheets look stronger in 2010, underpinned by larger cash balances and comparable debt-equity ratios. Notably, the private corporate capex cycle is at half 2007’s run rate. Corporates have preferred to fund expenditure with debt rather than equity – the complete opposite of 2007.



Return correlations: Global conditions seem to be more mixed in 2010 compared to 2007. Central banks remain accommodative – especially in the developed world, which is struggling with growth rates. Significantly, the correlation of returns between Indian and emerging market equities is almost 10 percentage points higher in 2010.



Valuation dispersion: Equity valuations were richer in 2007, both on an absolute and relative basis. The market cap to GDP was close to 150% by the end of 2007 whereas the number is around 100% currently. To us, the most striking difference is the dispersion of valuation across the market – the dispersion has been much higher in 2010, signifying selective market behavior.



Consensus behavior: Consensus earnings estimates have been largely flat in 2010 – whereas in 2007 estimates rose sharply in the second half of the year as the market made robust gains. Domestic mutual fund flows were strongly positive in 2007, whereas they have been suffering successive months of outflows (the worst ever in history) in 2010. The market was clearly more exuberant in 2007 whether measured by breadth of market performance, the extent of hedging (much lower than in 2010,) or the deviation of the narrow index from its 200 DMA.



Sector performance: One of the biggest differences is sector performance. Relative performance is the opposite for each and every sector, except for financials which outperformed in both years. The most notable differences are in utilities (which was the best performing sector in 2007 and has been the worst in 2010), technology and energy. The smallest gaps in sector performance are in financials, telecoms and materials.



The similarities between 2010 and 2007: Industrial growth and net buying by FIIs in the equity markets seem comparable. The sell side consensus appears to have the same conviction levels, though the net buy ratio started at low levels in 2010 and has risen through the year with the market. In contrast, the net buy ratio in 2007 remained unchanged through the year and at close to record highs.