by Shiv Kapoor
Quant & AOM Editor
Gurgaon, India (DYDD)
Sensex has risen from 19,426.71 on 12/31/12 to 19,894.98 on 1/31/13. It has risen 2.41%.
NIFTY rose to 6,034.25 on 1/31/13 from 5,905.1, rising 2.2%.
INDY tracks the NIFTY, much of the difference between NIFTY’s performance of 2.2% versus INDY’s at 4.8% comes about as a result of strength in the Indian ₹. The $/₹ exchange rate for 1/54.773 on 12/31/12 and 1/52.289 on 1/31/13. Using these exchange rates we get a $ NIFTY level 107.80 on 12/31/12 and 113.25 on 1/31/13; a gain of 5.05%. The remaining difference of 0.25% is probably made up of a combination of fund expenses and tracking error.
Whether you look at INDY, Sensex or NIFTY, it is clear that SP500 (Up 5.04% for January) and Dow (Up 5.77% for January) soundly outperformed India during January.
The strengthening ₹ is however a sign of risk on. But the fact that SPY and Dow outperformed NIFTY/Sensex is a sign of risk off.
I run a Sensex & NIFTY value weighted portfolio. This is re-balanced & re-weighted monthly. In my view, a value weighted portfolio should, in the long term, outperform a price or free float market capitalization weighted index. Because individual stock prices move with enthusiasm from month to month, I monitor this on a monthly basis. It also allows me to view individual stock price movements and valuation levels to form a view on risk. In addition, when the portfolio does under-perform I want to know why, because that often tells a story on risk attitude and money-flow. You can see this Sensex & NIFTY portfolio for the month of January lower in this post; and if you would like to follow the portfolio performance in February, you will find it here.
The value weights are calculated using an equity risk premium model, which calculates exuberance to despair values, based on what long term real expectations should be for a stock with a certain beta.
The beta adjusted return expectation is calculated as Rf + β * (Rm-Rf); where Rf is the risk free rate (I use the 10Y India bond real yield over the long term); Rm is the real long term return from Indian equity markets over the long term). β is a more complex calculation which I won’t get into here; you can obtain β from quotes in Reuters. Keep in mind that in sectors where beta is below 1, I allow greed to play a role in looking at long term return expectations. For cyclical sectors, I am fearful so I use β to calculate what the β adjusted return expectation should be; but for defensive sectors, I am greedy and I use a β of 1, if the beta is below 1. Both cyclical and defensive sectors have earnings expectations adjusted for the typical cyclicality in earning during the course of an economic cycle for buy and hold values and despair values. The intrinsic, price target and exit values do not adjust for cyclicality in earnings. You can find the equity risk premium model used for this exercise here. There is an alternative equity risk premium model for $ investors here. This model uses US home market equity risk premiums and applies it to Indian stocks after adjusting for both the beta between SP500 and Sensex and the Indian stocks beta versus the Indian index.
Now during the October to December period, the Sensex & NIFTY value weighted portfolio outperformed the NIFTY by 554 basis points and the Sensex by 508 basis points. January has seen a reversal, with the value weighted portfolio underperforming the Sensex by 165 basis points and the NIFTY by 144 basis points. Why?
The first point of interest is that the index rose even while 29 stocks fell and 22 rose. If you look at the NIFTY members which carry a weightage of over 5% you will find that ITC carries a weight of 8.7%, Reliance Industries 7.7%, ICICI 7.2%, Infosys 7%, HDFC Bank 6.3% and HDFC (who owns a chuck of HDFC Bank) 6.3%. The value weightage system says that:
- ITC, a defensive stock is over-valued; thus it has a low value weighted portfolio allocation. The stock rose 7.27% this month.
- Reliance Industries is a cyclical stock which is under-valued. It rose 5.61%. Since the value-weighted system essentially equal weights all stocks and then adjusts that for valuation, the allocation in the value weighted portfolio was 2.24%; well below the free float market capitalization (FFMC) based allocation of 7.7%.
- ICICI Bank is an over-valued cyclical stock. It rose 4.65%. The value weighted allocation was 1.51% compared with FFMC allocation of 7.2%.
- Infosys is an undervalued cyclical stock. It rose 20.3%. But the value weighted allocation was 2.52% versus FFMC allocation of 7%.
- HDFC Bank is an over-valued cyclical stock. It fell 5.24%. The value weighted allocation was 1.4% versus FFMC allocation of 6.3%.
- HDFC is an over-valued cyclical stock. It fell 5.1%. The value weighted allocation was 1.28% versus FFMC allocation of 6.3%.
Axis Bank Ltd, Bharat Petroleum Corp Ltd, DLF Ltd. HCL Technologies Ltd, Oil and Natural Gas Corporation Ltd; stocks which are several of which are influential in terms of market capitalization had monthly price rises of over 10%.
What I am seeing is money flowing into mega-caps, regardless of whether they belong in cyclical or defensive sectors. And flowing out of mere large caps, regardless of whether they belong in cyclical or defensive sectors. It reflects a light risk off situation, but it’s not ugly; for it to be ugly, the money flow would be directed primarily to defensive sectors, which was not the case.
Part of the reason could also have been ETF money flowing; which kind of explains the strength in the Indian ₹ too. Part of the reason could be a lack of domestic participation; these would tend to be more focused on mid-caps and large caps with mega-caps attracting less flow. Part of the strength in the Indian ₹ is coming from active policy accommodation and promotion of India as an attractive foreign investment location. It is also in no small part due to our Finance Minister taking very active steps to reduce the fiscal deficit. Chidambaram never seems to amaze me. He has managed to make considerable progress while acting on behalf of a coalition, which does not enjoy majority.
On balance, with money flows to mega-caps, and the underperformance relative to US, I believe we are seeing a degree of risk aversion building in India. The ₹ strength is an offsetting factor, indicating continued risk on, but I believe it has more to do with policy action, than with risk. Since it comes on the back of aggressive risk taking in November and December, it could be what the doctor ordered. The key for now is to watch the Sensex & NIFTY portfolio in February; you will find it here. Watch out for mega-cap cyclical stocks losing leadership; that would be very bearish. If we see participation spread, the markets will rally; watch the large caps, particularly the large-cap cyclical stocks for a bullish signal. Watch the defensive stocks too; if the price rise is moderate compared with cyclical stocks; it will be bullish. If we see defensive stocks rise aggressively at the expense of cyclical stocks, or if we see defensive mega-caps rise as defensive large caps fall, we will have a problem. Remain watchful.
As of now, the fiscal policy environment in India is very supportive of a resumption of growth. Monetary policy is turning neutral from tight; an incremental positive. The risk is from contagion resulting from a recession or significant growth slow-down in developed markets. Despite the Indian economy being led by the domestic consumer, the impact of contagion is high. Imports remain elevated as export markets contract; this impacts the fiscal deficit and the current & capital account deficit. It transmits to the domestic economy through crowding out of private investment, rising inflation (import push) and as a result a rising interest rate environment. In addition, the source of the first ₹ of income matters. I believe the first disposable income in India arrives from IT export services. This along-with a multiplier effect, creates a virtuous cycle of consumption which spreads through the domestic consumer. Take away or reduce the level of first disposable income and the virtuous cycle reverses.
Valuation in India is no longer supportive; increases will have to come from growth and if the growth cycle does resume with its customary vigor, the gains could be significant. There is reason to be optimistic on a renewal of the growth cycle. But there is a risk of non-occurrence in the event that there is an enduring and substantial slow down, or recession in developed markets. As of now, I expect any slowdown in US to not be of such magnitude of duration that it would impact the Indian growth cycle. If I am wrong, the Sensex has downside to a buy and hold value of 18,765 and a despair value of 14,500; you can see the equity risk premium valuation here. This model currently recommends an equity allocation of 59.5% for an investor who would typically allocate 62.5% to equity.