Investors, the bumpy ride to Sensex 60,000 begins this year

Looking at the behaviour of the domestic stock markets, and the success of fixed-rate issues like the tax-free bonds of the National Highways Authority of India (NHAI, which was a super sellout), it is easy to conclude that investors have become even more risk-averse than before.

True, but they are being so at their own risk.

The fact is, despite the current policy paralysis and general air of pessimism surrounding the India story, the medium-to-slightly longish term (5-7 years) future of Indian stocks has never been better.

In fact, in an earlier article, I had predicted that the Bombay Stock Exchange Sensex will easily hit 60,000 by 2018-20. I would like to give further evidence of the same. Let’s start with the US markets.

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A recent article by Floyd Norris in The New York Times suggests that the US markets have entered a period of low growth. If the 1984-1999 period saw the S&P 500 giving a real annual return (after inflation) of over 15 percent, in the last 15 years, this is down to 3 percent. It seems the cycle starts reversing once returns top 15 percent.

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Says Norris: “Broadly, it appears there is a cycle that is repeating itself, in which the 15-year return tops out at more than 15 percent and then falls precipitately.”

It was the rising cycle that made investors like Warren Buffett stand out as super-achievers in the past. In a falling cycle, they won’t.

If the 15-year cycle observation holds true, what is the possibility that long-term investors will stay invested in US stocks when there are better pickings elsewhere? Especially India, where the market has fallen 23-25 percent in the year to date?

The second point relates to the dollar-rupee rate. Thanks to market pessimism, the rupee has been the worst-performing currency in the emerging markets, and has fallen 19 percent against the US dollar in 2011. The logical explanation for this is that India’s current account deficit (CAD, which is over 3 percent) and inflation rates are bad - hence the currency depreciation. But as Abheek Barua and Shivom Chakravarti point out in Business Standard, Turkey’s CAD is over 10 percent but the Turkish lira fell only marginally last year.

Clearly, the gloom in India is overdone - and the rupee will rebound this year. At the cusp of that sentiment change, foreign investors will start piling in to take double advantage - of a strengthening rupee and a rising market. The two go together.

Let’s also not forget that while the rupee is weak, domestic manufacturers get better protection, exports become more competitive, and high exchange earners get windfall profits in terms of unearned foreign exchange gains. The losers are the ones with high debts designated in dollars. If you pick companies playing in the domestic markets, with low dollar exposures, and/or high export capabilities, you have a winning portfolio on hand.

Third, there’s the interest rate cycle. Everyone and his aunt has been saying that the interest rate cycle has peaked, and the question is no longer whether the Reserve Bank will reverse its tight money policy, or cut rates, but when.

While some say the rate cut cycle could begin as early as January, even if this is postponed to March, the fact is no further increases are possible anymore.

Stock market valuations and interest rates are inversely related. If rates have peaked, stocks should be bottoming out, too. While no one can say when the actual bottoming out will occur, it is a safe bet that 2012 is probably the year. Investors, take note.

The fourth point is inflation. An elevated average inflation rate is going to be the lasting legacy of UPA’s profligacy (with NREGA and Food Security being the important wage-price spiral boosters, and fiscal looseness, necessitated by the need for greater subsidies, being the other key inflationary factor).

This means we are going to see 7-10 percent inflation for the next two or three years, and possibly slightly lower inflation after that.

When inflation rises, the rupee value of corporate profits rises as prices adjust for inflation. If the big index companies grow at 15 percent in real terms over the next six years, and inflation is at 10 percent in the next three, and five percent after that, stock prices have to rise 25 percent over the next three years and 20 percent over the years after that just to compensate.

Whatever happens, inflation itself should call for a stock price correction to Sensex levels of 50,000-60,000 over the next six years.

This is not to say that the index will not fall to 12,000 in the short run. But in the medium term there is no way we are going to lose out by investing in stocks.

In fact, if the US is going to have a 15-year downcycle, India should correspondingly have an upcycle. The upcycle that began in 2003 will last us at least till 2020.

A caveat to investors: this is not an invitation to take extraordinary risks. Every investor should stick to her or his asset allocation. If your ratio is 50:50 for risk investments and safe avenues (as mine is), stick to it. Don’t raise your equity investment to 75 percent of the portfolio.

However, it is worth remembering that at 8.2-8.3 percent, even the tax-free NHAI bonds yield a negative return after inflation. In the next few years, the biggest risk we face is our inability to take risks.

The ride will be bumpy, but by 2018, you will be sitting pretty.