Second part of my column on forecasting market direction. The article is reproduced below.
The author takes a macro look at liquidity & interest rates, two key market direction components
By Anand Tandon | May 26, 2012
In
my previous column, I had discussed growth and valuation as two
components of my four factor model for determining market direction over
the medium term. In this column, I discuss the other two macro
components – liquidity and interest rates, and how to tie up all the
factors to estimate market direction.
Liquidity
Liquidity can be interpreted in various ways. In simple terms it
determines the extent of mismatch between demand and supply of money.
Since monetary authorities often attempt to “manage” liquidity through
market operations, a market driven measure is difficult to find. We
often have to do with proxies.
At a macro level, liquidity can be measured through money supply
(called M3 by economists). As the graphs demonstrate, M3 as a forecaster
of market direction worked well for most of the decade of 2000. Post
2008, the correlation between market direction and M3 apparently broke
down – central bank interference has, since, become the norm.
Other measures of liquidity can be FII flows, the liquidity
adjustment facility of the RBI or measures such as TED spread (price
difference between three month futures on US treasuries, and the
identical contract in Euro).
At the level of the market, liquidity is easier to measure.
Volatility can be taken as a proxy – lower the volatility, higher the
liquidity. Other measures include impact cost of trades (difference
between the buying and selling price) or intra-day high-low of stock
prices.
Whatever the measure, the impact is likely to be the same. Easing of
liquidity conditions helps in taking the market up. The reverse is true
when money becomes tight.
An interesting outcome of this is the impact on “mid-cap” or
less-traded companies. Smaller companies usually trade at a valuation
discount to the larger, well-traded companies. This often leads “value
investors” to invest in these companies. While this may be a valid
strategy for someone having an investment horizon exceeding 5 years, it
can be painful for investors (or fund managers) who look for near term
performance.
When liquidity dries up, the smaller companies are the
first to feel the impact of tight liquidity and fall in stock prices of
such companies is usually steeper than their larger (more liquid)
counterparts. In other words, invest in mid-cap value only when
liquidity conditions are benign, and are likely to remain so. Value
investing can easily become a value trap for the unwary.
Interest rates
Interest rates are fundamental to valuing any asset – financial or real.
At the heart of investing is the desire to earn a return that preserves
or grows the value of money. Interest is the benchmark for measuring
the effectiveness of any investment. Since the concept of interest is
relatively simple, I will not attempt to explain it. However, I have
often observed that most people do not realize that value of all
investments fall when interest rates rise – equity, debt or real estate.
A simple way to understand this is to see all assets as generators of
cash flow – dividend, coupon rates or rent. We use present value of
these cash-flows to measure the value of each investment and that uses
interest in the denominator. In other words, unless the cash flow from
investment increases when interest rates rise (for example, in the case
of inflation adjusted bonds), asset prices will fall when rates rise.
Another point worth mentioning is that liquidity and interest rates
do not need to move in the same direction, though they may. It is
therefore necessary to examine each separately.
In the market, all interest rates are not equal. I had earlier
referred to a study by the RBI where it postulated that inflation rate
below 6 per cent may help growth while above it, it is likely to harm.
Likewise, when interest rates rise above 7-8 per cent (from lower rates)
impact on markets is more adverse. Increase in rate from say 4 to 5 per
cent is less likely to impact. This is explained by the assumption that
at lower levels, the differential interest rates can be passed on to
consumers – without impacting corporate margins and therefore protecting
(enhancing in nominal terms) the cash flow. However, higher rates meet
consumer resistance forcing companies to absorb the rate increases with
consequent lower margins. Likewise, on the way down, a drop from 8 to 7
per cent is more likely to have a positive impact than one from 10 to 9
per cent.
The last question to consider is what interest rate we are referring
to. For the purpose of the stock market, we should look at the borrowing
cost of companies. Since this varies from bank to bank and company to
company, it is normal to consider the base rate of banks. Even simpler
is to track the repo rate: the rate at which banks borrow from the
reserve bank.
Putting it together
In the very short term, liquidity overwhelmingly determines the
direction of the market – higher liquidity leads to higher market levels
and vice versa. However, over the medium term, say 3 to 6 months, the
dominant factor is the earnings and its growth. Higher growth will
support higher levels. In a benign interest rate scenario, or one where
interest rates are expected to fall, valuations will rise.
In all this, change in levels is more important than the level of
each variable. However, when variables cross thresholds (for example,
interest rates go beyond 8 per cent, or earnings rate falls below 15 per
cent) the impact is greater.
In the current context, as we mentioned earlier, earnings growth is
expected at 12 per cent (anaemic but better than last year: positive),
interest rates may fall further (they are at the threshold of 8 per
cent: a further cut can have a large upward impact on markets:
positive). Liquidity is poor (M3 is falling: short term negative), but
valuations (at around 13-14x: positive) are at the lower end of the 12x
to 18x band. Downside in the market can therefore come from liquidity
shocks. Otherwise, potential upside to downside risk is in favour of the
equity investor. Buying dips may work well for the patient investor.