Is Sensex following Salman Khan's fortunes? Smart investors should stay invested

Explaining the market’s short-term direction is a mugs’ game. Even before one has finished explaining why the Bombay Stock Exchange Sensex went down like a stone the other day, today (8 May) it is seems buoyant. After Wednesday’s 723-point drop, around noon on Friday the index was up by 430 points, living it up on the right side of Mount 27K.

Human beings want stories to explain everything, and so marketmen will spin tales around why the index went down or up. The truth is post-facto explanations need to be taken with a pinch of salt. It is always possible to cobble together a bunch of “facts” to explain Sensex behaviour. None of it actually makes much sense.

Correlation is not causation. One might as well claim that the Sensex crashed Wednesday due to sorrow over Salman Khan’s conviction for running his SUV over pavement dwellers 13 years ago; it’s up today as he’s got bail.

Convinced? No? Consider how relieved Bollywood is - with so much money riding on Salman Khan staying out of prison. When Bollywood is fine, the Sensex will be too.

However, seriously speaking, it is a fact that the Sensex has fallen more than 10 percent since its March intra-day peak of 30,000-plus. But we need not look for explanations in the current alignment of stars, frmo heaven or Bollywood. The real explanation is simpler than it may appear.

The 10 percent—plus drop is unrelated to any fundamental economic factor that may have worsened the outlook since March. All it represents is a correction from the overblown expectations of a quick revival after Narendra Modi came to power. After a night of binge drinking, the Sensex is having a hangover. This too shall pass.

This is not to say that the explanations given for the market’s southward direction are all wrong. They have a ring of plausibility. Among the major explanations offered are that the Modi government is unable to deliver reforms due to his party’s weakness in the Rajya Sabha and its recent electoral loss in Delhi (this, when the insurance, coal and mineral bills are passed, and GST is halfway through); the MAT tax demand on foreign portfolio investors (FPIs) has unnerved them (this is a red herring, as we shall show below); corporate earnings are still under pressure (but this is an overhang from the past, not a new affliction post-Modi); the land bill will not pass (this is true, but compromises are likely to see some version of it through by the end of this year); interest rates are too high (but they have peaked); and bad loans with banks are a big problem (this is a real issue, but will probably be resolved in the coming months).

Barring MAT, none of the issues is actually a new concern. So they can hardly explain why the markets fell on 6 May. Or why they lost the buoyancy seen earlier this year.

Consider what is happening even on MAT. The government is slowly backing off and a committee has been set up to review the issue. Not only that. Far from the scary Rs 40,000 crore retrospective tax burden being bandied about when the MAT issue first surfaced after a ruling of the Authority on Advance Rulings, the actual number of tax notices issued to 68 foreign entities is all of Rs 602 crore . This is loose change for investors, even if they had to cough it all up – which too is unlikely.

Make no mistake: MAT is a bureaucratic goofup driven by a babudom that is trying to drum up revenues any which way it can in a difficult year. MAT will be resolved after some more weeks of ministerial waffling and committee jaw-jaw. No government really wants to upset investors. Especially “phoren” ones.

Also consider the real issue: when FIIs have invested Rs 42,397 crore in equity and Rs 43,484 crore in debt this year, how big is the real threat of tax notices worth Rs 602 crore? It is a fleabite even if left as it is. So MAT is not the explanation for the market decline.

Now consider the real deal. Ask yourself: what you would do as an investor if you have made tonnes of paper gains on the stock markets over the last 18 months. Will you be greedy and wait for it to make you even more money, or will you cash in some of the gains, so that at least some of the paper wealth shows up on your bank balance?

If you have invested relentlessly over the last 12 months – over Rs 2,80,000 crore of net FII investments in equity and debt – would you not want to take some profits home?

This is exactly what is happening. In May so far, FIIs have sold around Rs 7,500 crore worth of stocks and debt, and this could continue for a while. Foreign investors are trying to encash some of their wholesome profits of the past, and the MAT issue has come in handy to provide a cover for their selling. Who knows, if they play their cards well, they may even get a complete MAT reprieve, and that’s like the icing on the cake.

Here’s my take: the smart money is not going anywhere, despite numbers that indicate that foreign institutional investors (FIIs) have been selling shares of later. They are merely acting sensibly as any investor would. Also remember: if all the FIIs head for the exits, they will be shooting themselves in the foot. Heavy exits depress the rupee, thus negating all their paper gains. What they gain on the stock markets, they will lose on the exchange rates.

Now consider what the experts would have said if the markets had risen instead of fallen in the last few weeks. They would have said reforms are taking root (insurance, coal, minerals bills passed, GST coming up next), inflation down, CAD in control, fiscal consolidation underway, IIP on a slow recovery path, government getting more realistic about seeking opposition cooperation to get bills passed, Sangh parivar playing quiet, corporate bottomlines close to bottoming out, etc.

Post-facto market explanations are about looking out of the window and then saying it may rain now. The experts will say the glass is half full if the Sensex is rising, and it is half-empty if it is falling.

The objective reality is that the economy is reviving a bit too slowly for the market’s comfort. But it is reviving. In April-February 2014-15, the IIP rose 2.8 percent , nothing to write home about, but a darn sight better than the stagnation of 2013-14, when the index fell 0.1 percent.

Corporate earnings may be weak, but the Sensex’s price-earnings (PE) ratio is around 19 – roughly the middle of the long-term range of 11-27. So, effectively, even at the current corporate earnings rate, the index is neither overvalued nor undervalued, judging purely by the PE ratio. Forward PEs, based on next year’s potential earnings, may actually show potential for Sensex rise. There is nothing fundamentally wrong with current index and share values (which is not to say specific shares are not overvalued or undervalued, but the market as a whole is not overpriced).

The economy may not have hit its stride, but it is recovering. Let’s forget the new GDP series, using which the Central Statistics Office said India would clock 7.4 percent growth in 2014-15, setting the stage for over 8 percent in 2015-16. Under the old GDP methodology, growth was 4.5 percent in 2012-13, 4.7 percent in 2013-14, and was expected to be 5.4 percent in 2014-15. This is recovery all right, though excruciatingly slow. Assuming the same trajectory, we can say that even using the old GDP measure, growth should be around 6 percent this year – nothing to snigger about.

Take another measure – the ratio of market capitalisation to GDP. At Rs 99,52,112 crore, the total value of all the listed stocks in the stock market is just about 70 percent of the country’s projected GDP of Rs 1,41,08,945 crore in 2015-16. Even Warren Buffett would not say this is an overvalued market (1:1 is where he would start getting worried). Even though there is no rule which says that markets should always be at a certain level vis-à-vis GDP, the fact is by no basic yardstick is there any reason to panic about current or recent past market trends.

In fact, the only factor that decides prices is liquidity – the amount of money chasing stocks at any point of time. Currently liquidity may be tightening temporarily due to FII profit-booking, but this is more than likely to be compensated by higher domestic buying (mutual funds bought Rs 16,700 crore of equity this year), which could strengthen if the Employees’ Provident Fund Organisation (EPFO) starts buying equity, as it has now been mandated to do. Business Standard estimates that upto Rs 90,000 crore of EPFO money could flow into equity over time. A new equity T-Rex is about to be created over and above the Life Insurance Corporation and mutual funds.

The reason why the markets get pneumonia when the FIIs sneeze is that there has been no countervailing force to balance their entry and exit. Over the next few years, as Indian pension and provident funds grow in size and start investing in equity, the FII factor will be stabilised by domestic investment in equity.

The short point is this: the markets may go anywhere in the short term, but the medium to long term is still looking good. There is nothing – absolutely nothing - in the fundamentals to suggest that the market should head down for a prolonged period. So, sit tight, and wait for the Sensex to rediscover its mojo. It surely will. Only we can’t say how soon.

The bull market isn’t over. The bulls have merely turning sheepish, for having celebrated hard too quickly since late 2013. They are now locking in some gains, so that they can stay invested for the longer term on a more sensible foundation.