Forecasting Market Direction - A Macro Perspective

A two part column which I had written for Wealth Insight for March and April. Can't locate this in their website, so I am posting from my own copy.

Investors constantly seek an answer to the question – “which way is the market headed”? Answers usually take the form of unsupported opinion –“ I think it will go up/Down”. Sometimes, it involves some arcane justification – “India is a growth market and will therefore go up”. The quantum of solace the first response provides is dependent on the profile and reputation of the speaker. It is totally unhelpful to the questioner in making decisions in the future. The second response is even more useless in terms of its information content. India was always a growth market (in terms of GDP) , but equity markets have remained in a range over 16 years of the past 20.

A systematic investment plan helps to remove the requirement of market timing. However, it requires investors to take a really long term view of investing and have the patience to sit through long periods of no gain.

A macro approach to market timing

Markets respond to many factors simultaneously. Often, investors are not able to identify the primary driver of market movement, and when to use what indicator. I present a simplified formulation to help decide the market direction over the near term (say the next 6 months) on a broad brush basis. A word of caution - when we use macro numbers that change slowly – sometimes once in a quarter or so, the indicators are not in a position to forecast daily or even weekly moves. At best, they provide a framework within which near term movements can be viewed or interpreted.

My simple framework has four components – growth and the price of growth, money and the price of money. Let us look at these in some detail.

Growth

This indicator is among the most common indicators in vogue. A growing company will, over time, generate more wealth as compared to one which is not growing or growing slowly. The underlying assumption is that there is some “equivalence” in the capital employed, and the risk of the operating business. A company may generate a higher profit or cash flow if it has more capital than its peer. That does not count. Similarly, a business that is more risky will need to generate a higher return to attract investors. In all this, we speak of growth in profits. There are several subtleties here – a growing company which is rapidly adding customers will, perhaps in the near term, lose money (for example the early stage development of telecom companies), but may be an attractive investment. This is because investors assume that when the rate of client addition slows, profits will shine through. There are other issues, but I want to skip these and keep it simple.

How do we estimate growth? and especially for the market as a whole? The way we get this is by taking the consensus of the estimates made by analysts tracking the companies in an index, say, the sensex, and then combining it in the same proportion as the company’s weight in the sensex.

For example, current estimates for sensex earnings are :

Table 1	FY12E	FY13E
EPS (sensex)	1163	1303
Growth	5.4%	12%
P/E (@ sensex of 17360)	14.9	13.3

The “price” of growth

The price of growth is commonly called “valuation”. Since investors prefer a company that is growing faster to one that is not, there will be a tendency to pay more for growth companies. In other words, the growth is often “in the price”. We therefore need to compare the “valuation” ie, how much are we paying to own a share of the company for each rupee of profit that the company earns. The ideal way to compute this would be a “discounted cash flow model”. However, a rule of thumb that works reasonably is P/E. A company with a high E/P (earnings yield) is generating profits that are priced more reasonably, as compared to one with a lower earning yield.   As always, there are several issues here. P/E does not take into account the capital employed to generate the returns. Take the case of two companies below:

Table 2	Company A	Company B
Sales	1000	1000
Profit from Business	100	100
Shareholders fund used	100	200
Equity Capital	100	100
Reserves	0	100
Earning per share (EPS)	Rs 1	Rs 1
Price per share	Rs25	Rs 25
P/E	25	25

On the basis of EPS and P/E, it appears that the two companies are identical. Clearly they are not – “B” uses twice the amount of shareholders capital as compared to “A”. Of course, this will be reflected in the share prices of the two companies (they won’t be equal as assumed above). The point to be remembered is that Return on Equity (RoE) is far more important that P/E in looking at investments. But, we use P/E as a proxy since it is easier to compute and understand.

 

How do we use P/E? First we must have a benchmark. The graph shows the rolling P/E of the sensex over the past 25 years. When smoothed over 5 and 10 year periods, it is clear that the valuation of the market rarely stays at or below 12x, generally trades at 14x-16x and except when in a raging bull market (1992, and 2000) rarely goes beyond the range indicated.

It appears that with the current estimates for consensus earnings (Table 1), we are trading at 14.9x march ending 2012 earning, and 13.3x next year earnings. In the context of the earlier graph, the market is “cheap”

I will discuss the other two factors in my next column, and then propose a simple method to use them as a general guide on when the allocation to equity assets can be increased. On the data discussed so far, it appears that while earnings growth will increase (the previous year EPS was 1103 – which implies a 5.4% growth from FY11 to FY12e), valuations are relatively cheap – should you be increasing your equity asset allocation? Perhaps, but we will find out.