Time to bet on defensives and banks

On global front some interesting trends are emerging – while the US dollar is strengthening, the emerging market equity indices and commodity prices are falling. The US jobless rate declined to a six-year low at 5.9% in September and service industries in the US expanded significantly. The strengthening of the US economy has led to weakening of other major currencies with the Japanese yen depreciating to six-year low of 5.1%.
The fall in emerging markets was led by severe fall in equity indices of China and Hong Kong, which is hit by unrest. Surprisingly, India outperformed the most during September, falling a mere eight points.

The widespread fall in commodity price is quite rare in recent times. Last week, the crude oil (Brent) price fell to 27-month low (since June 2012) of less than $92 per barrel; the platinum price fell to 5-year low at $1,256.30 per ounce; and gold prices fell below $1,200 as investors sold about 9 tonnes of gold held through ETFs. About $1,200 is believed to be the average cost of gold production. There is a myth that the gold price cannot fall below its production cost. The annual production of gold in the world accounts for only about 2% of global demand – the remaining 98% of demand is met by what is already available above the earth. Hence, the continuous withdrawal of fund by gold ETFs can pull down prices another 10% in the next few months. It is too early for Indian households to bet heavily on gold. While copper price touched 3 ½-month low, the iron ore price has fallen 42% year-to-date in 2014. Other commodities which got weakened substantially in recent weeks are natural rubber, cotton, wheat, palm oil, etc.

Warren Buffett said last week that his investment in Tesco Plc was a "huge mistake" – the share price of Tesco, the UK's supermarket leader, remained at 11-year low. The failure of this super market partly reflects the economic stagnation of euro zone. While the most economies other than the US struggling, can the domestic equity markets remain so robust?

India has its own set of problems – soaring fiscal deficit, poor export growth, stress on banking assets due to coal blocks cancellation and banking credit growing in a single digit are the areas of concern at present. In this background, the Sensex trades at just 3% all-time record high seen in last month. Moreover, large number of midcap stocks trade in the range of 20 to 35 PE! Some smallcap stocks trade at PE multiple higher than what the respective industry leaders enjoy on the markets.

Of course, the long-term structural bull run remains quite intact – however, in the short term, the domestic markets especially the over-valued midcap stocks may see some correction. By December end, the US Fed would end its monetary stimulus and is likely to reverse the interest rate cycle in January-March 2015 quarter. India has to roll over $174 billion external debt repayment by March 31, 2015. Hence, there would be further stress on rupee in this quarter. Considering these facts, it would be wise for the investors to reduce exposure to overvalued midcap stocks and lean on defensives in IT and pharma sectors and follow bottom up approach in the midcap space without losing valuation comfort zone.

The writer is managing director, Equinomics Research & Advisory Pvt Ltd