November 11, 2012
1) Magazine covers with blaring headlines that a new bull market has begun.
There is an old wall street aphorism that nobody rings a bell at the top of a bull run or at the bottom of a bear market. However, magazine covers can and do act as contrarian indicators that signal a reversal in fortunes. Magazine covers, especially business magazines, are one of the best indicators that can be used to time the top or bottom in a long-term trend.
A prime example of this contrarian indicator in action was the April 2010 issue of Newsweek which ran the title, “America’s Back!”
We all know that the remarkable tale of America’s turnaround was nothing more than a mirage created by a flood of central bank liquidity that primarily served to boost the prices of risky assets. The US is currently facing the weakest recovery in post-World World II history. Thus, the claim that “America’s Back!” is premature at best. There are other examples of magazine covers serving as contrarian indicators, but I’m sure you get the point. Thus, the recent cover story by Business India titled A New Bull Run in the October, 2012 issue doesn’t augur well for the formation a true bull market.
2) Valuation levels don’t indicate oversold and overly bearish sentiment.
According to Pring Turner Capital, “A secular trend is formed when a series of business cycles are linked together establishing long periods of stock market out or under-performance. These patterns typically last up to 20 years.” Cyclical bear and bull market cycles in contrast to a secular cycle occur in accordance to the general pattern of the business cycle, which is comprised of expansions and recessions. Thus, there could be multiple cyclical bull and bear markets within the context of a larger secular bull market. Similarly, there can be multiple cyclical bull and bear markets within the context of a larger secular bear cycle. I would consider the rally from the March 2009 market lows a cyclical bull market within a wider secular bear market that began in 2000. Typically, bull markets begin at secular turning points when optimism about the future of stock returns is at its lowest and valuation levels as reflected in the market P/E multiple are near single-digit levels. Essentially, an ongoing secular bear market slowly erodes investor confidence and optimism. As a result, we see a decline in the amount investors are willing to pay for each dollar or Rupee, in this case, of earnings per share. Ultimately, you reach a point where stocks are truly undervalued, which sets the foundation for the next bull market. For additional confirmation, you’ll most likely see magazine articles touting the “death of equities”. At this point you can be reasonably sure that a new bull market is about to begin.
In the chart below, we can see that the Nifty is currently trading at its 10 year average historical TTM (P/E) multiple, represented by the red line. Unlike the scenario in December 2008, when P/E multiples were well below the 10-year average, it’s difficult to make the argument that Indian equities are cheap on a historical basis. In my view, the market would have to de-rate significantly from current levels to make the case that a new sustainable bull market was forming.
3) Decoupling is a myth. Emerging markets, including less export dependent countries such as India, can’t grow independently of the US and Europe.
Despite the prospect of unlimited quantitative easing, the US economy is showing no signs of a recovery. The trend of rising profits and revenues at the largest US corporations is coming to an end. Profits and revenues have been expanding since the third quarter of 2009. According to Thomson Reuters profits for the largest US corporations are expected to decline by 1.8% in the third quarter of 2012. The stock market continues to remain priced for continued growth. As the US economy continues to slow, corporate earnings will disappoint. As investors face the reality of a potential recession in the US, the outlook for equities remains dire.
Although the crisis in the Eurozone appears to have died down, the economic outlook continues to deteriorate. The Eurozone PMI for October was 45.8, down from 46.1 in September. Combined output of the manufacturing and services sectors dropped at the fastest rate since June, 2009. We can see in the chart below that changes in the PMI (blue line) lead changes in GDP (orange line).
Gary Shilling has created the term the “Grand Disconnect” to define the current dynamic of weakening global economies failing to deter overly optimistic investors who are hooked on massive monetary stimulus by the world’s central bankers. Eventually the disconnect will be resolved. It’s most likely that investors will one day wake-up and realize that massive doses of monetary stimulus have only an ephemeral impact on asset prices and no lasting impact on the real economy. It’s unlikely that the Indian market will be able to decouple in the event of a global market sell-off. More importantly, given the global outlook for economic growth it’s unlikely the Indian market is beginning a new bull run.