We put out a note yesterday morning, citing a comparison of this bear market with historical bear markets. When I looked at the metrics, the sentiment and historical VAR, I looked at the change and realised that volatility is where the Relative Strength Index (RSI) is, where valuations like price to book, equity and bond yield gap are. Almost everything is hitting a new low. A lot of it has passed the bear market lows. The metrics are telling me that we have hit a bear market trough.
Of course, there are some imponderables and as usual, every bear market is different. The imponderables are usually different and that is where we do not have a comparison with the past. We needed to note three things: a) This market has not really spent enough time around its lows and usually bear markets last for at least six months if not more. 12 months is par for the course. This one is just two-month-old. The price decline is around 40 per cent which is a little shy of what other bear markets have done, which has been around 50 per cent, . The Great Financial Crisis (GFC) was 60 per cent. So, we have not seen that duration. We have also not seen a peak in volatility. It seems like it is peaking because it has gone past the GFC high, but until it actually peaks, I do not think we can have complete confidence that the bear market trough is upon us.
So a lot of metrics are telling us that but these are the couple of things that are not yet satisfied. The imponderables around this particular bear market are two-fold. One is of course the impact of the virus and how it spreads. To that extent, what we got from the Prime Minister yesterday was extremely good news because if we are locking down this country for 21 days — we see it has been implemented so far with great seriousness.
We will be in a position to manage the community spread phase of the virus pretty well. So far, the numbers have been pretty well contained and hopefully they stay that way. We will also have to look at world data because the virus has to be contained in other parts of the world and that will impact how share prices behave in the near term.
The second and most important thing is policy action. We have not really got much except for some changes on regulations and reporting requirements yesterday and a little bit of liquidity infusion from the RBI and of utmost importance now is to get this policy action going because there is a severe economic impact of this. The more time we spend doling out that action, the greater will be the pain in the economy. These are my thoughts.
On the policy front, we keep hearing that it is going to be coming soon. If we do see an aggressive fiscal stimulus plan coming in from the government, will it help mitigate the economic impact that we are foreseeing for the next six to nine months?
There are three things that need to happen. First, you have to protect the banking sector because that is where the pain is the worst. Manufacturing companies will lose a month, two months, or three months of production. They will be back on their feet and they will basically have lost one quarter of earnings. At worst, that is not going to impede their ability to do business after that.
However, if financial firms start facing losses on their loans very quickly, they can face terminal positions because after all, they have the ability only to take a 10 per cent drawdown on loans and then they run out of capital. It is of utmost importance that the financial sector is protected and to that extent, the forbearance for all corporate loans is important for the next one year at least. We should not be looking at how these NPAs are reported. So, forbearance is one important step in the RBI domain. The RBI of course will couple this with rate cuts and with more liquidity to keep the market going.
Second, the public sector banks have been infused with capital over the past several months and are also sitting on a large deposit base and a much lower credit to deposit ratio. They need to be urged, almost instructed to lend money to stressed sectors. We need to see the loan growth accelerate and it should be monitored on a weekly if not a daily basis and that number should go to 15-20 per cent so that we know that credit is going out. This will allow businesses to support their existing cost structure. They do not need to fire people because otherwise, businesses start losing cash and they will have to take extreme steps with respect to fixed costs.
Third. we have a low oil price. Hopefully, it will continue for a while. We can hike taxes there very quickly and take that money and give it to sectors that are stressed; give it to MSMEs, the auto sector, the aviation sector, where there is direct impact from the virus.
There are lots of other suggestions that are coming out but I will stop here because I think there is a fair bit that the government can do. A fiscal constraint should not be of any consideration right now because in all likelihood, this is a temporary infusion of money into the system. We can keep aside all fiscal concerns right now and act on the economy and then come back to worry about the fisc later.
How does one model a sector like IT completely dependent on manpower? IT services are not essential services. The mix is anywhere between 70 to 30 onsite versus offshore. A lot of offshore business now goes down the tube. What happens to sectors like IT which perhaps is not prepared for a lockdown?
I am reading the government’s press release and IT and IT enabled services have been identified as essential services. You are in a position to actually start a server and a lot of these companies are extremely sophisticated and have very good systems for work from home. I do not see why they cannot continue functioning. Just productivity may drop a bit. I have been working from home for the past several days and there is some drop in productivity, but it is not zero. A lot of these firms are actually very enabled.
In fact, I would worry more about small and medium size businesses which do not have the concept of work from home and which have to interact with the customer on the ground. IT is always interacting with the customer over the wire and so I do not think they are that hurt. It is a separate problem how the business comes in because their customers are located in places which are far more severely affected by the virus than we are like the US, Europe and it is quite possible that business may slowdown, new business may not come in and to that extent there will be some impact on earnings and revenues. That is certainly an issue but I do not think the ability to execute current business has been impeded a great deal.
Which are the pockets of the market or the economy where you think disruption is temporary and demand will come back? Also which are the pockets, companies or businesses where we are in for a long winter and this disruption will continue?
That is a very hard question for me to answer. Frankly, we do not know how people will react and how long this virus problem will linger. The way we can think about it is firstly how long it goes on because the longer it continues, the longer will be its memories and the shorter it is, the shorter will be the memories. For example, say we win this battle on 13th April and on 14th April by the actions of the government, we are business as usual after the expiry of 21 days. I think the memory of the virus will fade very quickly. As such we have not faced that much casualty or medical problems. We will be quickly back on our feet.
If problems mitigated by mid April, financials will lead the bounce-back, followed by the consume discretionaries.
Now the opposite example is suppose this does not actually get solved by the middle of April and lingers on for longer and suppose there is flare up in cases due to a community spread. That will leave the memory imprinted with more fear and then the recovery will take longer. So depending on what happens, you will know which businesses are affected now. For example, the travel industry will take a little while to come back. People will be hesitant in the beginning to travel and you can see that in the share prices. I don’t think we need to think much about this.
This is like the corporate governance episode that India faced in 2009, when people called me and asked which are the companies facing corporate governance issues in India? I said, look at the screen. All the stocks that are deeply in red are the ones that the market has judged have corporate governance issues. The market is pretty good about this. Financials lead the pack where the share price damage is the maximum.. In financials, it is not that the damage has already happened but the risk that has happened is very high and the market has singled out financials.
If the problem is mitigated by the middle of April, then you would also see the biggest bounce in financials and then you can see the travel related businesses and the ones that require people to move around are the ones still in pain. The usual consumer businesses should be back. There is a possibility that industrials may take a little while because it will be some time before companies actually get their act together and put capex in place.
Therefore industrials may actually see some delay in order and may be that would not happen now before 2021. That is the way to think about it. We can never be sure about how this will all pan out until we know the worst moment of the virus is behind us. The worst moment for the market may be behind us, but for the virus it may not be.
Is there a case to be made that financial markets have reacted well in advance and there is a serious case to be made that markets may actually bottom out early and the economy may not bottom out so that we will not get good news on the economy front but we may start getting good news on the stock prices front?
That has always been the case with share prices. Markets tend to discount the future and they tend to second guess it and the crowd acts very smartly in most of these circumstances. The share prices are going to put the bottom well before the economy. When and where that bottom happens is always hard to tell. The strategy has to be that prices are kind of destroyed right now. You make a second guess about what long term cash flows are and there are lots of stocks out that are screaming buys. That is why I am of the view that we may be skirting the bear market trough just on the basis of how share prices are, rather than making a forecast of what is going to happen with the virus and the economy in the next six months.
Which are the other stocks which are screaming buys?
Financials is right on top of the list; the second would be consumer discretionaries. Discretionary consumption will come back and there will be pent up demand. That demand is not lost. The demand is lost wherever there is an element of time involved. For an airline, it’s demand which is permanently lost because of expiry of time.
But discretionary consumption will come back because people still need to consume autos and they need to do a lot of other stuff which they have not done in the last one month. We may want to do so for the next one month or so. So, that is the other space.
I like energy. It looks like oil prices are going to remain low for a while and Indian energy companies are benefiting from that.
Industrials is where you want to be a little bit more cautious. If you are running a portfolio and you need to fund all this, then I would use technology to fund it because the Indian economy will snap back if things do not get worse from here. Technology may underperform in that event. The work that I did going back in time shows that Indian EPS growth outperforms the world EPS growth in all bear markets. We tend to be far more defensive because most bear markets are created around global factors whether it is GFC, whether it was the tech bubble burst, 9/11 or whether it was the Asian financial crisis.
All major bear markets in India brought upon us were by global factors and in those bear markets, we tend to outperform fundamentally because we are relatively unaffected by these things due to our inward looking economy.