Markets may be fairly valued, but that’s no reason for the bulls to cheer.

TOO HOT TO HANDLE

Markets may be fairly valued, but that's no reason for the bulls to cheer. The leading indicators point to a rough ride ahead and that's good news for those sitting on the fence

THE benchmark indices in India are up by a mouth-watering 20% in the past three weeks. Encouragingly, bulk of these gains occurred in the last five trading sessions. The speed and magnitude of the rally left many observers scurrying for answers. While it is always difficult to guess the market's next move, the latest recovery has given rise to all sorts of speculation and forward-looking statements, with the street equally divided between bulls and bears.
    This constant tussle between bulls and bears is enough to unnerve the old-timers; we can just imagine the plight of retail investors who are sitting on the fence looking for the right opportunity to make their moves. This is a time to go back to the basics. Around a year back, we at ETIG had devised a simple and more intuitive way of estimating the right market level –tracking trends in the dividend payouts by companies. The historical data suggests that the movement in benchmark indices closely follow the long-term trends in dividends, albeit with a lag.
    This should not be surprising. After all, the prevailing stock price is nothing but the current value of all future dividend payouts by the company. In the absence of this, equities will become a "big ponzi scheme," where you buy a stock expecting the other guy to buy at a higher price and so, on without any underlying value. But why should the last guy be left holding a useless piece of paper?
    The relative co-movement in Nifty index value and dividend payouts by 50 companies comprising the index is shown in the chart below. Both dividends (actual) and Nifty are indexed to 100 at the beginning of the period starting on 1st Jan, 1999. The chart demonstrates a close corelation between the dividend and Nifty trends. Whenever the Nifty trendline overshoots the dividend line, it declines to close the gap and vice versa. This happened during the dot-com bust of 2000, the stock market crashes of May 2004 and June 2006. And whenever dividend outgrows index, the Nifty catches up albeit with a lag such as was the case in 2003 and 2004.
    So what does the dividend line say about the current rally, which has taken the Nifty to 3100. As is evident from the chart, the Nifty is fairly valued at its current level with both the trendlines blissfully kissing each other. However, there's a caveat. The dividend data for most Nifty companies pertains to FY 2007-08, which was incidentally one of the best years for India Inc. Given the state of the economy and corporate health, most observers expect a cut-back in dividends by a majority of companies. This
will push the dividend lower and not higher, as the bulls would like it to be. In the last economic downturn in late 1990s and early part of this decade, the decline in dividend payments was to the tune of 10-20%. And in many cases, dividends dried out completely as companies turned lossmaking. The latter is already visible in the auto sector. Even if we assume an average 15% dividend decline for the market as a whole, the Nifty's fair level is somewhere between 2500 and 2600. Now you know why the market keeps bouncing back from that level, which is also described as a strong support by many experts.
    The above prognosis is supported by various macro and non-equity indicators. One of the most obvious is the yield on the government bonds, which is currently on an upward curve. The government has announced plans to auction bonds worth a whopping Rs 240,000 crore in the next six months. Such a heavy borrowing programme will not sail through at the current interest rate levels. The government will necessarily have to juice up its bonds offering with higher yields. This will have a cascading effect on the entire economy, including the stock market. If the borrowing costs of the best borrower in town go up, the interest rates applicable to corporates and individuals will just shoot up. While this will raise India Inc's interest payments and lower profitability, it will further diminish the demand for interest rate sensitive products such as passenger cars, commercial vehicles, high-end consumer durables and housing. All this is negative news for the equity market. Anyway, there is always a negative correlation between interest rates and return on equities. Being a risky asset, equities thrive in an environment of low interest rates and easy money. That period is firmly behind us for now. So then where do the investors go from here? Our one-line advice to the retail investors is to stay way from pull-back rallies in the near future. Market reversals are equally sharp and it's difficult for retail guys to catch the momentum and reverse their positions at the right time. Retail investors are better advised to buy their favourite stocks on dips. And blue chips are a must-buy below the Nifty's 2600 level. This is a natural level for the near term and the market will always try to come back. However, even at current levels, quite a few blue-chip counters are available at historically low valuations. If you buy at regular intervals, without waiting for the market bottom, you have a greater chance of capturing at least a part of the bottom. As we have always been advocating, this is the time to start planning for your retirement. Because 20 years down the line, no other asset will match the cash flows that equities can provide.
krishna.kant@timesgroup.com