In a recent post I said:
"For India, the picture is more confusing. I do not think Sensex should fall below 17,200-17,500 range; but this level could break if SP500 falls fast and hard. On the other hand, a fall in US would be led by a decline in risk aversion; if that takes the pressure of commodities, it could well be good for the Indian economy. But falling risk aversion also means foreign investor capital outflows, which means a further fall in markets unless domestic investors step in; I doubt serious domestic value buying will come in at over 16,000 to 16,500 level. All in all, I have no firm conviction in what may happen on the Sensex, they are too many variables. A fall to 17.2k levels would be followed by investment to eliminate of equity under-weights caused by the market decline; a further fall to 16.2k would lead to an additional investment to eliminate of equity under-weights coupled with additional investments to overweight equity by 5%."
The "too many variables" have shrunk – with ECB indicating a first rate hike in April, 2011 and expectation of QE2 finishing on or before 30 June, 2011; this should bring money flows back to India, where growth expectations and visibility over the course of an economic cycle remain strong. Until there is more clarity on oil prices, the main caution is that transition from mid cycle expansion to late cycle expansion can be volatile; yet I would be very surprised if Sensex fell below 16,700 even if SP500 declines 20% from its peak. On the other hand, a rise in SP500 to 1,400 could leave the Sensex at 21.8K if median economic cycle relative valuations come into play.
I suspect that the DM Vs EM trade has almost run its course; with QE2 expected to have run its course by 30 June, 2011 and the ECB indicating the first rate hike in April, 2011, money flows will likely flow back to emerging markets, where economic cycle growth expectations remain solid. A shift in focus to growth over an economic cycle and away from single year growth models would be supportive to India relative valuations; such a shift would be appropriate during late economic expansion. I calculate the Sensex & SP500 PE 6 as average annual price divided by 6 year median EPS and the relative PE 6 as Sensex PE 6 divided by SP500 PE 6. The relative PE 6 between Sensex and SP500 is at 1.40. This compares to decade median relative PE of 1.56. This indicates mild under relative valuation in India relative to US. I calculate the Sensex and SP500 PE as average annual price divided by EPS and the relative PE as Sensex PE divided by SP500 PE. The relative PE between Sensex and SP500 is at 1.09. This compares to decade median relative PE of 1.00. This indicates mild over relative valuation in India relative to US; though keep in mind that the median relative PE since 2006 is 1.13 (which indicates the Sensex is at a slight relative under valuation with relative PE at 1.09).
Remain watchful on oil prices – a prolonged stay (three months) above $100 on WTI could well result in a very short late cycle expansion and usher in a recession earlier than is otherwise normal - this would move money away from risk and equity and lead to sharp contraction in multiples and market values. If oil sustains at $100+ for the next three months, I would look for a recessionary global economy starting in September/October 2011; with markets pricing that risk by July/August or somewhat earlier – in terms of absolute lows, I will expect 850 on SP500 and 10,000 on Sensex by April/May 2012.
The market bottomed in March 2009. The US recession ended in June 2009. The early phase of expansion ended in May 2010; this is about the time when global interest rate (hikes start Australia Oct 2009, Brazil Apr 2010, India Apr 2010, Canada Aug 2010, China Oct 2010 and Russia Feb 2011; its also around the time where cost of debt started rising due to sovereign debt concerns - rates rose regardless of no change in benchmark rates) start normalizing. I suspect the mid stage of the expansion will end July-Sep 2011 or thereabouts – with QE2 ending on 30 June 2011 being very likely and the ECB signaling a first rate hike in April, 2011, I firmly believe we will move into the late expansion phase of the economic cycle - this could actually signal the start of a global mid cycle expansion and not an entry into the late cycle because it is the start of the process of rate normalization in globally dominant US and European economies. Data viewed neutrally suggests the mid cycle expansion could continue until mid to late 2012, my views have a bearish bias calling for an earlier end to the mid cycle expansion and thats based more on the broadly weak global economic structure - high deficits, saving and consumption ratio discrepancies between DM and China, structural global trade and invisible imbalances, rising structural long term unemployment (even while unemployment rates drop) in DM's, global capital flow imbalances and public & private debt excess - but perhaps my biggest reason for belief in a shift to late cycle expansion is recent historic sector behavior - energy has been outperforming since Nov 2010 and energy outperformance normally occurs in very late mid expansion and late expansion. For more on sector behavior during economic cycles, Fidelity has an interesting view on sector performance through the economic cycle which you can read
here. I do not agree with their analysis in all respects, but overall it is a good tool and guide.
Now during the late cycle expansion, market returns are normally subdued. In fact during secular bears such as those evident in the US, the late expansion should provide negative broad market returns and more severe negative returns during the next recession (bottoming three to six months prior to the end of the next recession). Generally, a trading range with a downward bias during the late cycle expansion and sharp contractions in value with capitulation occurring three to six months prior to the end of a recession is what can be expected. Despite pessimism on broad markets, sub markets which remain in secular bull formation should continue to provide positive returns (albeit subdued relative to the past two years in absolute terms) during the late expansion – secular bulls remain BRIC markets and commodities (agro/metals/oil). In addition to energy; material sectors, which are in secular bull formation, defensive characteristics from staples and healthcare sectors should also perform quite nicely; these four sectors can be over-weighted. Industrials and utilities could hurt as could IT and consumer discretionary sectors; these sectors can be under-weighted. Financials and Telecom should be market-weighted during the late expansion. Ignoring sectors, defensive characteristics from strong dividend yields and low leverage stocks should also perform.
