20-25% chances of Sensex stooping to 11K

20-25% chances of Sensex stooping to 11K
Ridham Desai for Money Control.com

Ridham Desai, MD and Co-Head-Equity, Morgan Stanley feels that one is likely to see more downside before market bottoms out and there’s 20-25% probability of the Sensex going down to 11,000. The market may take some more time to form a bottom, Desai said. He alsosaid that, the price correction shows that India may be in a bear market. Desai said that, most indicators show that the market is in a 'fear zone'. On a more positive note, he affirms that the market may see an end to the pain by the third quarter of this year

Desai is skeptical about whether companies will disclose their losses this quarter. He feels that the valuation gap between sectors needs to narrow down. He further added that if India falls another 10-15% as against other emerging markets, it will create a buying opportunity.

“It has not satisfied the time requirement because bear markets usually are longer. It has definitely satisfied the price correction requirement. We have been through a couple such corrections in this bull market. If this is not a bear market then it could turnout to be like May 2004 or 2006 when we went through a similar type of price corrections. This time around, the fundamentals are under the scanner and that’s what makes me feel that this is a bear market. We may have a little bit more time to go before we get to that so-called bottom,” he added.

Excerpts from CNBC-TV18’s exclusive interview with Ridham Desai:

Q: Are we in a bear market?

A: It looks like one. It has not satisfied the time requirement because bear markets usually are longer. It has definitely satisfied the price correction requirement. We have been through a couple such corrections in this bull market. If this is not a bear market then it could turnout to be like May 2004 or 2006 when we went through a similar type of price corrections.

This looks more like a bear market because the fundamentals in 2004 and 2006 were different. In May 2004 and 2006, the macro was pretty much intact and we got some global surprise which has caused markets to correct in terms of valuations. We found a bottom very quickly and the markets rallied all over again. This time around, the fundamentals are under the scanner and that’s what makes me feel that this is a bear market. We may have a little bit more time to go before we get to that so-called bottom.

Q: What's your definition of a bear market? There are many definitions, some say a 20% fall is enough for a bear market, but obviously you define it differently?

A: 20% is one criteria, another criteria would be the 200-DMA. From 2003 till now, we have had only one penetration of the 200-DMA and that too for a very brief time in 2004.

Q: This time we are consistently below it.

A: Yes, we are consistently below it. One should look at is falling intermediate tops and bottoms. That’s another thing that was not met in the previous two corrections of 2004 and 2006. In that there were one or two falls and then the market actually did not establish lower bottoms. This time we are getting consistently lower bottoms and tops. So, that feels like a bear market if you look at the long-term trend lines.

I am not a big believer in trend lines because you can draw many lines through two points and justify a lot of things on trend lines. But these are the three things that I look at. The percentage of fall, are successive tops and bottoms lower or higher, and how long we stay below that 200-DMA? The percentage of fall at 20-25% is a good number. We have at least three bottoms which have been lower than the 200-DMA and have been staying below that for a while.

Q: Is history a good guide to how long bear markets typically last or have things changed because one contention has been now-a- days that the bear markets are much shorter, so we don’t need to worry about 4-6 quarters it will all get over in two quarters?

A: There were three bear markets since the early 90’s. We had the Harshad Mehta scam-related bear market that lasted approximately 50-weeks and the fall was about 50%. Then, we had the mid-90’s emerging market sell-off, which produced 55% fall and lasted about 86-weeks. Last, we had the tech bubble where the price fall was approximately 50%, but it lasted longer. It took 110-weeks for the markets to bottom out.

This is what distinguishes this time from the previous and this is debated quite hotly because this is intuition rather than based on any facts or data. India has moved on structurally, we are not the same economy that we used to be in the 90’s. Therefore, to argue for a100-week prolonged bear market like we had gone into during the tech bubble days or in the mid-90’s will be a little bit too aggressive.

We will probably get a 50% fall if this turns out to be a bear market. In terms of depth, you will still get that 50% fall and several parts of the markets are already down 50%, so we are getting there. In terms of length, we will not get the type of the 90’s bear market that we got, so this will be shorter. May be it will last for another 15-weeks but it won’t establish the 70-80-90 week period that we have seen in the past.

Q: What would convince you that it is a bear market? You are saying it could be a bear market, which you think is likely. But it could also be a deep correction in a bull market. What would utterly convince you that this is a bear market that we have entered?

A: From a fundamental perspective, it is earnings because bear markets never come with earnings rising and that too at a base of 20-25%, which is what we have all got used to. Even in the early and late 90s, we got earning declines. So, maybe we don’t get earnings declines but get a slowdown in earnings. So, that is one thing we need to watch out for. When earnings start declining, we know that it is a bear market. So, that is fundamental.

Technically, I am kind of more or less convinced. There is not much room left because the market breadth has collapsed, midcap index has collapsed, several sectors with fluff have gone away, and the momentum stocks have gone away. We have discussed this 200-DMA, the tops and bottoms have fallen. So, I cannot imagine that there is much of a debate there.

The debate will be on the earnings and fundamentals. Have they peaked or is this just a mild correction and we are going to recover pretty quickly? So, if that is going to now fall then this is a bear market.

Q: The scary bit is the 50% number that you are working with. In past bear markets, we have fallen 50% from the top.

A: Yes, we have fallen 50% or slightly more.

Q: Is it likely then that we will go back from that 21,000 peak to something like 10,500-11,000?

A: We need two conditions to get there. First, we need some extensive turmoil in global financial markets beyond what we have already had. We need some more things to happen, maybe Europe will get into trouble, or may be non-financials in America will get into trouble. We need that because without that I do think India on its own is going to slip into a 50% correction. Second, we need a policy mistake at home.

It is a challenging time right now. Growth is slowing down, inflation is rising, and it is an election year. These conditions are similar to 1996 when growth had peaked out, inflation was rising, and we were in election year. If there is a rate hike, or there is a response from the policy side which accentuates the growth slowdown, then we could argue for a 50% correction. Otherwise, we may miss that precise 50% point and may bottom out before that.

Q: What kind of a probability would you attach to it happening?

A: A 20-25% probability of the Sensex going to 11,000. We will probably bottom out before that.

Global financial market conditions may not worsen dramatically from here. It may spread a bit in the US. In the US, the pain in the financial sector is probably behind us. We may get some pain in non-financials, industrials, and materials notably. In Europe, we may see a bit more pain because they have not really seen that pain. But it may not be a catastrophe. It may not be like what we saw in the US, it may not be like a Bear Stearns effect. We have seen some pain come out in the last one week and the markets have responded well to that. So, we may get a bit more pain, but nothing of the nature that we need to take the markets down another 20-30%.

At home we look okay. We are getting some response from the government, which is the right response in the circumstances. So, we don’t want the central bank to come around and say okay, inflation is high so let me hike rates because our own view is that rates are already prohibitively high. They are already in restrictive zone, and they need to be lower. If you hike them further, then growth will probably fall even harder and that will create a problem for the markets here. It will be hard to recover from those lower levels later on. So far, as we don’t do that, I feel confident that we may not do that. I think we should be okay.

So, we may not get to 11,000, but it is still a one in a four chance. We may bottom out before that.

Q: It is a general feeling in many quarters that we may have in some sense established a near-term bottom. We won’t violate that because we have been just hovering around those 15,000 levels. Do you think that is a bottom or you would be surprised if that turns out to be a bottom?

A: We need a confirmation from companies on how much they have lost on their balance sheet and off- balance sheet trades. Until, companies come and tell us that the markets will speculate and will be nervous. That’s what the condition we are in right now.

Q: Can that end at the end of this quarter, if all disclosures are made?

A: I am actually skeptical that we will get all disclosures this quarter. I hope they come.

Q: Despite ICAI?

A: Yes, despite ICAI. We may not get it because ICAI does leave a room for you to disclose it in your notes. The notes will not be revealed until the balance sheets come out and that will happen only in August-September or June. It may actually go beyond this quarter. I hope that companies disclose it because if they disclose it the pain will be behind us and we will establish a bottom.

Second, we need commodity prices to come off and some dollar strength because of our inflation problem is not our problem. This time around it is actually the world’s problem and we are just importing that problem. It is going to be very hard to generate a response to that. So, we just plainly need commodity prices to come off. We need oil, wheat, and metal prices to come off.

Third, we need a little bit of despondency among retail investors. We have not seen that as yet. Retail investors are holding fort. It is quite remarkable that the market has come off as much as it has and mutual fund flows are still positive. If I get a month or two of negative mutual fund flows, I will feel a lot more comfortable that we have hit a market bottom.

Q: Do you think that the final capitulation hasn’t happened yet?

A: I don’t think so. That’s why I don’t think that the bottom that we have seen in the last couple of weeks cannot be violated. It can be violated and we could see some more downside before we bottom out. It has to be combined with these three things. I would add one more factor to this which is not an event related thing, but it is an adjustment process in the market and that’s valuation dispersion. If you look at the market even after what has happened, there are three or four sectors that are trading way above historical averages in terms of valuations and way below the gap which was much wider in January.

The three sectors on the higher side are financials, industrials, and utilities, while those that are trading at a discount are notably consumer staples, technology, and healthcare. The gap has narrowed because financials, industrials and utilities have sold off whereas staples, technology, and healthcare are relatively better but it is still there. If that gap narrows further -- so if financials, utilities and industrials compress, and staples like technology and healthcare stay put -- then we may also get that adjustment process required to establish a bottom.

Q: What about emerging markets overall because our rally was in sync with emerging markets and we have all underperformed the US big time this year? Do you see that continuing for the rest of the year? The US actually does not fall too much but emerging markets correct even more?

A: On the emerging market front, India and China were behaving a bit more differently from the rest of the emerging world in terms of valuations and performance. By early January, we were outperforming emerging markets by 30% from our August 2007 lows. So, we were significantly better off. Since then we have given up all the gains. Now, we are trading flat from August 2007, so that’s good news actually. That performance gap was a worry for me. We have given that up, at least relative to emerging markets. Now, we look better. Valuations were at a 100% premium on the January 9-10 peak, and are now down to 50%. I feel very comfortable with that

Q: Will that unwind more you think?

A: It could unwind more because we have domestic risk factors to deal with. So, may be it unwinds to 35%. If it goes to 35%, India becomes a very good buy relative to emerging markets.

Right now, it is neutral. It was a sell relative to emerging markets in January. It is now neutral. If it falls a bit more now -- another 10-15% relative to emerging markets -- we become a buy. From an emerging market standpoint, commodity prices falling, which is good for us, is actually bad for emerging markets because a lot of emerging markets are anchored around commodities. So, Brazil, Russia, West Asia, and even parts of Eastern Europe will suffer. India actually stands to gain, so if commodity prices fall and if that becomes a trigger, the country will actually outperform. That could be a major differentiating factor going forward.

Q: If we just take out the off balance sheet items like derivatives etc, do you see chances of negative surprises in core earnings over the next three quarters?

A: There is risk because EBITDA margins are actually at an all-time high. They are sitting at five-year high levels and revenue growth will slowdown because GDP growth is slowing down. I don’t think we can runaway from the fact that the economy is slowing down, which is the right response or which was the response that we should have expected when the RBI tightened last year.

This is just a reflection of what has happened last year in terms of tightening and a reflection of the slowdown in capital flows. The economy is slowing down, revenue growth therefore has to slowdown, and so earnings will slowdown. The consensus is a tad too optimistic about earnings right now. We may actually end up getting lesser earnings growth that what is being forecasted by the street which is around the 20% mark. Earnings could probably slip into the low teens or even the high single-digits. It is quite possible that if things turn really bad and some of those worst-case scenarios turn up, you get actually a quarter or two of negative earnings growth which is definitely not out there.

Q: We could de-rate further then?

A: It is possible. We are trading at about 15 times on an absolute basis, and 50% premium to the emerging market multiple. Historically, we have traded at close to the emerging market multiples, so if things turn bad one could get a bit of de-rating for a short time. If such things happen, then you would have sold your house and buy equities. Then, you satisfy the condition to really buy equities in a big way.

Q: Just one more point on sentiment. You spoke about retail not having had that capitulation yet but when you measure global and local sentiment, do you think there is more downside or do you think we are pretty much at the lowest ebb of sentiment?

A: We have a proprietary sentiment indicator where we combine 15 market matrix. A lot of them are suggesting that we are in fear zone. That’s good news. I like that because fear is essential ingredient to market bottoming out.

So, I am not getting granular about this. Normally, I don’t because I just take the composite reading and say okay, this is fear, euphoria. Now, I am getting more granular because we want to get more accurate about this. Then, there are a few indicators that are still not sold off enough or still not fallen enough. If they would fall more then we would have entrenched ourselves into a fear zone. So, from a sentiment perspective we would have probably kissed a market bottom.

Q: What's your best case in terms of the turnaround timing? If I put a gun to your head and say by when you think the turnaround will happen, given the three factors that you mentioned where would it be -- third quarter, fourth quarter, or next year? What is the highest probability of the inflation point?

A: May be by third quarter, we should have a lot of these things behind us. We will know by the third quarter whether commodity prices are going to fall or not and by that time the adjustment processes should have happened in the commodity markets. By then, we will know the losses that are there on balance sheets and the earnings slowdown that’s coming and consensus would have revised earnings lower. I am quite certain that by then retail would have given up as well, if the markets don’t go anywhere.

So, we would have satisfied a lot of these things. By the third quarter of this year, we should be okay. Therefore, long-term investors, and there are very few left these days in this market, who have a 1-2 years timeframe should actually start looking for stocks. This is a good time for them to start bargain hunting and there are a lot of places in the marketplace where things have turned attractive.

Q: Has it come as a bit of a surprise that in the last one-month, despite a fall of 30% on the index, a lot of the supposedly long-term money did not buy this dip, because at 21,000 there were a lot of India bulls? Some things have changed fundamentally but a 30% fall did not induce a whole lot of long-term money coming in?

A: It is also surprised me that institutional money has not sold heavily either and the markets have fallen 30%. We have not seen that type of selling, which if I go back to January and somebody had asked me what is going to trigger a market fall, and I would say that would be basically institutional selling. That never really came in a big way. May be we should be surprised because a lot of long-term investors were very bullish on India in 2007 and suddenly that bullishness has been threatened by a few events.

There isn’t that many really long-term investors left out there who have the luxury of taking a one-two year call. Most investors are by the mandates, which they have, forced to look at a one-three month scenario. The one-three month scenario still doesn’t look that comfortable for them to actually pull the trigger. Even the investors who are buying in this market are buying in very small quantities because they don’t want to commit their capital up front. They are saying let us put 5-10% today, and we will wait for another two-three weeks, see where prices go and put another 10%. Even the buying is happening in a very spaced out fashion. So, that doesn’t allow the market to actually bottom out.

Q: What is your base-case scenario because third quarter is the end of the pain and downside is what 10-15% from here at best?

A: I would be comfortable with 13,500 or so on the index which is the August 2007 low. We will test that. If one looks technically, the market has very strong support at 12,500. So, I am not thinking about that being broken at this stage. For that to be broken, we need really terrible news. Probably, we won’t break that but from current levels to 13,700 or 14,600 could get violated.

Q: Somewhere around July-August you think is the end of the pain?

A: Yes, third quarter is a reasonable timeframe.