Shankar Sharma of First Global expects global volatility to rise while he sees equities under pressure. In his view, volatility level may rise to its highest in the last three years. He believes that the US yield curve has flattened, thus warning of a slowdown.
According to him, valuations of banks and mobile phone operators are expensive. He also informs that, at First Global, IT is currently their favourite sector.
He also adds that there is a large probability of Sensex falling below 10,000 levels. Furthermore, he says that midcaps will be the worst hit in the correction. He mentions that Tuesday's gains are unlikely to be sustained.
Excerpts from CNBC-TV18's exclusive interview with Shankar Sharma:
How are you feeling about the market and do you think it is anyway near to settling down?
For the day anyway, I think it has settled down. You will see a bit of green on the screen today but we do not think going into tomorrow's session or for the rest of the week, the green will sustain.
What is worrying you? We had quite a fall of a couple of 1,000 points from the top. Why do you think there is more to go?
The thing about market is that things keep setting themselves up and the signs keep emanating. All of us collectively keep ignoring them and then suddenly one day all of us realize that all the factors that were being talked are dangers to the market and that's why these kind of sell off keeps happening with monotonous regularity.
The Yen Carry Trade is a bit of a red herring. So that is something that we do not pay much attention to. But the fact is that there was huge amount of global complacence, volatility was very low and just before the day China clamped down on the markets, we put out a note saying that the global wall was looking strong and set to rise and that has been the large factor in the overall global sell off.
India was even worse because we have been talking about India's market internals, which have not been good post-Diwali. People keep saying that markets adjust. But in fact, markets do not adjust, the only way they adjust is that they significantly correct and that's precisely what you are seeing just now. So you simply had just a handful of stocks driving markets up.
The rest of the markets were lagging; the old economy sectors like cement, construction, and real estate were trading at very economy valuations and the new economy valuations were more like old economy valuations. I think that simple imbalance has to get corrected and that's precisely what you are seeing just now. So nothing that we have seen so far, actually surprises us.
What is the most overriding concern in terms of global cues at this point; is it what is happening in the US or something quite else?
Our take is that in the US or for that matter globally for equities, we are going to see volatility go back to probably levels that were not seen in the last three years. If you look at the trend of volatility from 2003 onwards, that has been a steady downward trend. We think that the downward trend has broken, which means that then, there is a negative correlation between wall and equity markets. So you are going to see volatility rising and hence equity markets remain under pressure. That is the overall global factor.
The US slowdown, the recession. Greenspan keeps talking about several things in the same breadth. So I never pay much attention to him even when he was a Fed Chief. So that is something that is yet to be seen. But the fact is that the yield curve there has completely flattened just like it has happened in India.
That is, of course, an advanced warning to some kind of a slowdown. So you are going to see the US definitely slowdown significantly - whether recession or not, that is another matter and that does have its effects on the rest of the world.
We cannot ignore that, which means that the rate cycle will again turn down for the US. It may or may not turn down for India because we are completely different in terms of economic fundamentals. But the US factors will definitely be up on us.
But more than US factors, I think India's factors are very local and I think India's problem really emanates out of the fact that a lot of the strong pillars of this market, in terms of the sectors, are no longer looking very secured now.
Cement has been a good case in point, when we were paying extremely high valuations; they were right to correct. Now the catalyst can come from anything and the Budget was supposedly the catalyst. But cement had been weakening a good 20 days before that, so the Budget was only the icing on the cake.
So cement, real estate and capital goods have cracked - these are the sectors, the domestic consumption plays, which were driving the markets. They have really cracked. So what takes this market up? That is the key question here. The wireless telcos are extremely expensive and banks are reasonably expensive.
So what are you left with which has that kind of earnings momentum to surprise the market on the up, which can lead to multiple expansion? Other than IT services, which currently remains our favourite sector, we do not see much earnings momentum coming in from the old stalwarts of the market. This means that markets have to trade lower than where they are now.
How much more do you reckon from here?
For all you know, you could be trading below 10,000. If you were to simply do a broad analysis of the market between the banks and the wireless telcos, you have something like 35% odd or maybe little more than that of the market. You add the cement pack, you are up to over 40% of the market, capital goods - 50% of the market and that 50% is looking very shaky.
So if that were to sell off 20% from here, you are talking 10% straight away off the bat of the market just for that pack alone, which means you are knocking off something like 1,250 points approximately. When those sell off, the others also follow in some kind of tandem, which means that you see about 2,000-2,500 odd points on the market happening, I think probability is about 80%.
You would put your money on seeing sub 10,000 levels in 2007 for the Index?
Not closing, but I think during the year, you can definitely see those levels. Where the market closes on a particular day of the year is not of much significance. Where it trades for most of the year, is of significance. We think the markets could be trading lower than where they are right now.
Let me also add to that we are not looking at the reversal of the bull market. But a correction in a bull market can be quite painful, which is what we are witnessing right now. So one could see that we are at 3-3.5 years of bull market. A moderate year would be a year in which you are down 10% odd, maybe 15%.
On a long-term chart, this may not even show-up 20 years from now. But currently, all of us engaged in the markets, will have to feel that pain. So 87 doesn't even show off on the long-term chart of the S&P 500 of the Dow; but when it happened, it was doomsday. I think that's pretty much where we are. On a long-term basis, we are still okay, but this year maybe fairly treacherous.
Where does a cut like that leave the midcap universe?
Typically in all situations that lead to problems on the broad market, midcaps are usually the worst hit because they are companies that suffer liquidity crisis more then the large caps do - (1) large caps are sitting on cash (2) access to cash is always better.
And the other thing that a lot of the mid caps have issued a lot of convertible debt at fairly high premier and that's something that if the rupee were to depreciate and we have seen it starting to fall last couple of days and stock prices are also fallen, which means that you may have a huge debt overhang on number of corporate India's balance sheet. So that's the other problem that the midcaps have.
Other than that, there is value - there is no doubt about it. There are companies that are 10-11 times earnings but it doesn't mean much there could easily be 8 times earnings, which means they are off 25%.
We would still stick to the largecaps; within the largecaps to the IT services, where we think valuations relatively are most attractive in the last two years. We think you will save money, if not make some money in that space.
Has construction corrected enough for you because most of these stocks are down about 40% from their peaks or do you think they merit a further squeeze?
I think the best days for the construction sector is probably behind them. They have had a very good run for three years, which probably ended some time in the middle of last year. Since then, they have been struggling, margins have clearly been a big problem.
Coupled with whatever we are seeing on the cement and steel front, we are not convinced that they have the ability of the pricing power because at the end of the day, it is nothing but a fairly commodotized sector.
When these companies started to run, most of us in the market were big skeptics. You cannot have these companies making roads and flyovers suddenly become hot stocks, high fliers like new economy companies, but that happened.
The fact of the matter is that the business intrinsically is a tough business, low margins, virtually no cash flow.
Those kind of businesses have the time in the sun, we have seen them have it, we think that the best days are behind this sector and the other big problem is that they have gone into becoming landowners, real estate developers - that is a prop trading business, in which they will be completely exposed to the vagaries of the real estate market.
They are probably coming at the peak of the market cycle there - that is the other big problem that you have on the construction space, stay away from that. That is our basic take.
What is your advice to people who invest through mutual funds because they have been under pain for the last nine months. Largely, most funds have been underperforming the market because of the midcap situation, do you think that is about to change?
The underperformance is quite interesting because the underperformance is actually a reflection of the fact that the market themselves had become very narrow. If five stocks were contributing, then most of the market rally from the June lows, clearly no mutual fund can weigh itself 70-80% in those five stocks - that is just not good risk management.
So clearly, just because the market became so narrow, everybody, the biggest genius in the world would have underperformed the market.
So I do not put any blame at the doors of the mutual funds because they are doing what they are supposed to do, which is to manage risk prudently. And if they have to lag by a few percent points, so be it. Having said that, we think obviously the best place for the average investor has to be through mutual funds. There is no point in coming here.
So this game is loaded heavily against that upcountry investor. So for him, I do not see any other option but to still stick to the mutual funds. They had given you some pain but that is a reflection of the market.
They cannot walk on water but in the long run, I think the mutual funds will deliver what they are supposed to deliver, provided the markets do what they are supposed to do, which is that India will do okay over the next three-four years' time. But this year, do not get impatient, you have to live with this and let us be very clear about it.
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