Why optimism pays

The Samvat year gone by was one with positive performance in nearly all asset classes. But it was also a year of confusion and challenges and a year of fear. Still, both the global and Indian equity markets have bounced back quite smartly, especially in the past couple of months. What should we expect now? More importantly, if long-term wealth creation is your goal, what should you focus on?

Economists coin new terms and phrases every day and, thanks to the media and internet, all of us get to know these terms. Remember the catch phrases of 2012? Fiscal cliff, long term refinancing operations, quantitative easing (third round), policy paralysis… All these created confusion and apprehension and did their best to make investors stay away from equity markets. But most of these concerns added only noise to the market; at best, they had a short-lived impact. Those equity investors who took a more rational approach and a medium-term view saw good opportunities in every correction and made good returns. Ultimately, each of these terms were forgotten, as will the ones that will be coined in the future. 

It was much the same with negative questions. What if oil crosses $150 a barrel? What if Israel attacks Iran because of nuclear warheads? Who will win presidential elections, in India and in the US? What if no money is printed through LTRO and QE3? Investors who remained overly worried missed out each and every time on the subsequent rally — they failed to realise that the market was already pricing in all known negatives. 

So, the lesson is to ask more positive questions. For instance, how many investors are currently mulling over the market response if a solid agreement on the US’ “fiscal cliff” is reached? Or, what is the upside potential if the recently-announced policy measures by the Indian government actually gains momentum? Or, what if the Reserve Bank of India  cuts interest rates? Here are some positive takes on some domestic fears. 

Scams are good news

Corruption seems to touch every aspect of life in India, so the unveiling of new scams shouldn’t come as a surprise. Difficult as it may be, it is still possible to see a bright side to this. For instance, the telecom scam may have resulted in an estimated loss of ₹1.76 lakh crore, but the positive outcome is that every subsequent allocation will necessarily be on auction basis and will result not only in transparency but also bigger revenues for the government. Then, land acquisition has been a major area of concern for infrastructure development and industrialisation. But recent scams have forced policy-makers to act on the long-pending Land Acquisition Bill; once that is passed, it should help in setting up of large-scale industries.

Furthermore, it helps that reforms are finally on. After a long hiatus, a flurry of new policy reforms in September took investors by surprise, improving overall market sentiment. The end of policy paralysis and more importantly, the resolve to not roll back measures has, most definitely, enthused investors. 

Born sceptics

Indians are by nature very sceptical: we get swayed by near-term negatives. As it happens, the domestic macro environment in India is much better than its emerging market peers: compared with countries such as Brazil and Taiwan, India stands out as a stable economy. History suggests that high-growth economies go through a soft patch even during a secular bull cycle. With favourable demographics translating into a growth dividend and high savings rate, India has the potential to generate 7-8% real GDP growth in the longer run. Moreover, the volatility in Indian growth in its ongoing structural phase is remarkably lower than for many other countries.

So, what is the outlook? Macro headwinds that kept markets under pressure in the past year are subsiding at the margin. This is how key variables will look like in the next one year: inflation will be at the lowest level in three years and as a consequence, interest rates will be heading south. GDP growth will be higher next year compared with this year and the global liquidity environment will remain benign as major central banks will continue their easing bias. Corporate profits could be better next year on improving operating efficiencies and, assuming a modest 10% earnings growth, 12 months’ forward P/E multiple for the Indian market at current levels would be less than 12 times. Altogether making it a good time for investing in equities. 

Which asset class?

Equity penetration in India is very low while mutual funds have suffered cumulative net equity outflows of ₹41,000 crore since January 2009. Most of the money has been flowing into alternative investment opportunities, namely real estate and gold.

Even though returns from investment in gold comes primarily from capital appreciation, investment in equity generates an additional recurring annual profit of about ₹4.5 lakh crore (FY12), which gets compounded every year. At a modest 15% compounded earnings growth, the cumulative profits of Indian companies will be equivalent to that of India’s Mcap in the next eight years. Moreover, gold prices have been rising for over a decade now and are at an advanced stage. 

Real estate is a similar story. The past 10 years saw a frenzied boom in residential property prices, but this was after a prolonged period (1996-2004) of little or no appreciation. In fact, between 1996 and 1999, prices dropped by up to 60% and after stabilising in 2000, it took another five years for real estate prices to reach 1996 levels. Going by key variables such as house price-to-disposable income, the current real estate cycle looks mature.

Doubts still remain, however, on whether this is the right time to invest in equities, given the 20% rally year-to-date in 2012. It’s better to invest in a rising market that has already bottomed, rather than trying to catch a falling knife. Historically, if someone stayed away from asset classes just because of a 20% upward movement, they would have missed a significant rally in the coming years. For instance, after finally reaching the bottom by end-FY03, the Sensex rose over 20% in just one quarter, by end-June 2003. However, from there, in the next four and a half years, the index jumped over 470%. Those who stayed away at that point looking at the first 20% return would have missed the opportunity of the decade. 

History tells us that market returns are not linear. There are pockets of very high returns and vice versa. Of course, you can’t be certain of anything in life, but remain invested in order to reap maximum benefits from a better-looking equity outlook. As someone once said, “There’s no better time than the present to be better than we were yesterday.”