Nikkei

In my previous post on Nikkie (18^th September 2014) I wrote, “Nikkei played out exactly I have expected. It consolidated between 12500 to 1500 levels for more than a year. Nikkei, it has been in a 25-year long bear market. If we see the given chart Nikkie is trading at the upper end of the channel resistance. With yen breaking above 109 and expected to go up to 120+ levels, I think Nikkei will breakout and will enter a multiyear bull market”

Since then Nikkei moved up from 16000 to 21000 as JPY broke above 109 and moved up to 134 as expected in the post. Since then Nikkie consolidated between 15000 -21000 for more than two years and has broken out of the range. 

The arrow denotes the time when the buy call on Nikkei was given. 

If we look at the given quarterly chart of Nikkei, the break out of Nikkei looks more profound and it seems that finally, Japan has been able to move out of the bear market. 

The near term target for Nikkei is at 29000 and long term target could be as high as 40,000. Readers may remember that I first gave a buy call on Nikkei on 4^th may 2012 when it was trading at  9500 levels. 

US markets

In my previous post on SPX500 written on 22^nd February 2017,  I wrote the following  

  

1.)  SPX has negated the bearish doji in yearly chart which indicates very strong bullish momentum in the index

2.      The target for SPX will be ultimately at 3200 and unless SPX breaks below the support of the channel (yellow channel) this target should be achievable. 

The strong bullish momentum continued throughout the year and SPX is up by almost 14% since then. If we look at the current weekly chart for SPX500, the index has reached to a crucial resistance level of 2700. The index should face multiple resistance at these levels and it seems that a correction to 2400 – 2500 looks very likely. 

However, The long-term target for SPX stays at 3200 -3300 and index should resume its upward march after the brief pause which will be a good long-term buying opportunity. 

Summary:-

1.       Expect a 10 – 15% correction in SPX in next 6 months.

2.       Long-term target for SPX stays at 3200 - 3300

Bitcoin

Everyone talks about Bitcoin these days. I was just looking at the chart of Bitcoin and it looks like a perfect parabola. Generally, a perfect parabola is formed at the peak or bottom of the bull/bear market. 

This is not the first time Bitcoin is witnessing such parabolic rise. It had happened in 2014 -2015 when bitcoin moved up from sub 100 levels to 1127 and then fell to 200. 

Also, from the perspective of behavioural finance, when everyone starts talking about an asset it is generally a bubble.

Although, I do not have any fundamental view on Bitcoin, from my understanding of asset prices, it seems that Bitcoin is going to get interesting in coming days and it may not be pretty for many investors. 

Crude Oil

In my previous post on crude oil was written on August 2^nd 2016, I wrote: “crude oil will close this year between 35$ to 42$ while next year can be a bull market if things go well.” Yesterday crude closed at 58.59$ approx. 50% higher from last year, although the bull market did not shape out as expected. 

If we look at given chart for crude, we can see a strong resistance at 60 USD. This has happened despite so many negative news like the cost of production for shale oil falling below 40$, electric vehicles being a new rage, the US becoming a net exporter of oil etc.

Any breakout above 60 USD looks difficult, I think crude will consolidate between 50$ - 60$ before any further breakout which can push the prices to 70$ – 77$ level. I think the most likely reason for the breakout will be further deterioration in the geopolitical situation in major oil-producing countries. 

If we look at the long-term chart of crude, I think the bear market in crude oil started in 2008 and we are already into 10 years of bear market. I don’t think we are going back to 100$ levels anytime soon but crude is very likely to consolidate and trade between 50$ to 77$ depending on the geopolitical situation. I continue to maintain an upward and positive bias on crude oil over next 2 years with short-term correction looking imminent.  

Tech Musings - Its time to be bold

In my previous post on Nifty written on 22^nd Feb 2017, I wrote, “ Since then Nifty is up by almost 10% in last three months. As I have mentioned in my previous post I expect Nifty to perform spectacularly well in next two years. I won’t be surprised if I see Nifty breaching 10600 – 11000 by the end of current year.”

In another post written on 6th September 2016, I wrote, “We may consolidate between 8000 – 9500 for next year or so before we finally break out of this zone and we have a bull market which will take nifty to 14000 -15000 levels by the end of 2020.”

As per last Fridays closing Sensex is already trading at 31000 looks unstoppable. If we look at the given chart of Index we can see that Sensex has been trading a sideways channel since 2005. It is again near the resistance line, so either of the two things will happen:

1.       Sensex will face resistance at the channel and will correct from current levels

2.       Sensex will break the resistance line and we will see a bull market unfolding in India, something similar to 1988 -1992 where Sensex moved from 400 to 4000 and 2003 - 2007 where Sensex moved from 3000 to 21000

My regular readers would be aware that I have been calling for a long term bull market in India near the end of this decade.

In my post written on 30th November 2010, I wrote, “This is my preferred scenario where market will move side side ways between a range of 24000 - 12000 for next five years before it eventually breaks above the channel line and reaches 45,000 by the end of this decade.”

In another post written on 16th may 2014, I wrote, “If we look at the given chart of Sensex, it made a high of 25375 and had hit the upper end of the channel. I am not expecting a breakout of this channel anytime soon.  As per my understanding market should spend considerable time consolidating at these levels before they finally decide to break out. Any breakout of this channel will result into index moving up to 45000 to 60,000 in next 5- 7 years.”

If we look at the given chart of Sensex, I think time has come for it to break above the resistance level. I believe that Indian markets have the potential to double from the current levels in next 4 – 5 years on the conservative side. I won’t be surprised even if I see trebling of Index in next 5 – 7 years.

I know that the immediate question in your mind would be about the valuations which looks stretched at this point in time. So let us look at the EPS growth chart of Sensex. From 2001 to 2008 EPS growth was around 28% CAGR while from 2008 – 2017 EPS growth has been 4%. I believe that we will see massive EPS expansion going forward which will enable the Index to grow at 15% – 20% CAGR

Summary:-

1.        The bull market in India has just started, target for nifty is around 15000 – 18000 in next 5 years

2.        EPS expansion will happen.

3.        We have already seen a 10 years long time correction since the end of last bull market

4.        All credit for this bull market goes to the current NaMo govt and their economic policies 

US markets

In my previous post on SPX written on 6^th February 2016, I wrote the following, “S&P500 has now corrected towards the lower end of the channel. In the recent correction in January 2016, S&P500 made a low of 1812 which was dot on the lower end of the channel. Hence the first leg or correction in S&P500 is over. Although, this correction did not pan out exactly as expected. I was expecting simple price correction but this correction was complex and contained a larger element of time correction as well. So what should we expect from here?

There are two possibilities from here.

1)      S&P500 will bounce back break the previous highs and move into a new bull market

2)      S&P500 will break the lower end of the channel and fall further 15% to make a low or around 1500 -1600”

I further wrote, “As you can see most of the index are themselves into trading into a channel and have either broken down or are about to break down. Moreover, if you look at the yearly chart of S&P500 you will see that we are forming a evening star pattern on the candlestick charts. Hence I will conclude that the global equity correction which started somewhere in 2015 will continue in 2016.

Summary: -

1)      If S&P500 will fall below 1800 the next target is in the range of 1500 -1600.

2)      Don’t buy S&P500 unless it breaks above 2050 on weekly closing basis.

3)      I see the probability of further correction in global markets to be more than 70%”

Clearly market corrections did not happen as expected. SPX made a bottom at the low of 1800 and broke the resistance of 2050 and since then has moved up by another 10%. Most of the rally happened in the month of November and December 

If we look at the yearly chart of SPX, It has negated a two very bearish candlestick formation. The first one was a doji in 2011 and the second was a doji in 2015. It’s extremely unusual for any stock or index to negate even one negative formation on yearly chart, but S&P seems to have taken an exception to it. 

As per my understanding of technical analysis whenever a bearish formation gets negated, it means that the underlying strength of the markets are extremely strong (bullish) and markets will continue the upward trajectory irrespective of surrounding pessimism.

If we look at the given chart of SPX we can see that SPX has been moving in two parallel channel. The first channel lasted from 1997 – 2013 i.e. 16 years. SPX broke out from this channel somewhere in May 2013.  Till SPX stays in the upward moving parallel channel (yellow channel) and does not break its support the upside target for SPX should stay at 3200.

The last chart is a quarterly chart of US Treasury 10-year Yield. US   YR yield made a high of 15.82% in 1982 and a low of 1.318 in 2016. If we look at the given quarterly chart this is the first time in last 34 years that the yield broken out of a downward sloping channel.

This can lead to two possible scenarios

1.      Interest rates will again fall below the breakout line and interest rates will stay benign in US

2.      If Interest rates sustains above the channel breakout, then Yield will move towards 4% range.

Since I had some bitter experience with interest rates forecasting which is controlled by fed, I will abstain from forecasting interest rates but my best case expectations call for a breakout.

Summary: -

1.      SPX has negated the bearish doji in yearly chart which indicates very strong bullish momentum in the index

2.      Target for SPX will be ultimately at  3200  and unless SPX breaks below the support of the channel (yellow channel) this target should be achievable. 

Is it right time to buy?

Investors often ask this question is it the right time to buy? And there are no clear answers to this questions. Yet it is important to answer this question. Market participants use various matrix to judge the valuation of the index. The most commonly used matrix is price to earnings ratio (P/E) which can be calculated by dividing the Index by trailing 12 months earnings per share.

This ratio is simple and intuitive to use. Whenever P/E is high the markets are trading costly hence it’s better to reduce position and whenever the P/E ratio are low the markets are trading cheap hence its better allocate more capital to equity. But P/E ratios are not without its issues.

The problem is also to identify at what level the P/E ratio signifies richly valued markets or extremely cheap. There are no clear cut answers to this problem. Moreover when P/E ratio are trading at extreme levels there is either euphoria or panic in the market and people hardly have courage to increase/reduce allocations in those conditions.

Example of excessive optimism is 1992 and 2008 while examples of excessive pessimism is 1998 and 2003. Although economic tells us that we are rational beings, humans are emotional and irrational. Hence we need a mathematical model to take asset allocation decisions which does gets impacted by the extreme exuberance or pessimism prevalent in the market.

It would be prudent for long term investors who can shift their capital from debt to equity when markets are undervalued and vice versa.  This will not only minimize volatility but will also reduce the pain of seeing one’s portfolio in deep red when market corrects.  And if done correctly this will also significantly enhance returns for long term investors.

So lets us deal with the problem in calculating P/E ratio. As P/E is price/earnings let us examine how each of this component impact the calculation of P/E ratio.

Price as we all know swings between euphoria and panic. Price is a dependent variable in our model and is directly observable in the form of index.

Earnings is an independent variable and Earnings depends on lot of factors but the most important of them all is economic conditions. As we all know that there are business cycles where economy goes into rapid expansion and slow growth or stagnation/recession.

EPS growth rates rises rapidly during expansion and is higher than the trend growth or sustainable growth. As soon as the economy slides back into slow growth or recession phase EPS growth reduces or contracts below the trend growth or sustainable growth rate. Hence EPS itself went into the cycle of boom and bust which has immense impact on the calculation of PE Ratio.

In the below chart we can see the difference between the trend/sustainable EPS which I have termed as true EPS V/s Observable EPS or EPS data declared by the index. True EPS is simply the base EPS multiplied by the compounded annual growth rate of long term EPS growth. From 1993 – 2016 EPS Growth was a CAGR of 13.5% which roughly equates to the GDP Growth rate of 7% and inflation of 6% during this period. For calculating the Trend/Sustainable EPS I have assumed the base EPS to be 10 and P/E of index 10X when the index was constructed in in the beginning of 1979 

As we can observe in this chart whenever there is rapid economic expansion the observed EPS moves way above the true/sustainable EPS and when the economic conditions reverses observed EPS falls back to the level of sustainable EPS. This happened twice since 1993. Frist instance was from 1993 – 2000 and the second instance was from 2004 - 2008

Hence instead of using the observed EPS for calculating the P/E ratio I have used the true/Sustainable EPS to calculate the P/E ratio which I have termed as True P/E of index.

As we can see from the chart whenever the index trades close to 10X to 12X true P/E ratio it forms a long term bottom which happened in 1984. 1988, 2003. Whenever True P/E is trades above 40X this calls for a serious market sell off which happened in 1991 – 1992 and 2007 – 2008.

Here I must point out that the P/E ratio may look grossly exaggerated but this is because they are calculated using the true/sustainable EPS. As I have mentioned earlier whenever economy goes through a period of rapid economic growth the EPS expands way above the sustainable growth rate which in turn subdues the observed P/E ratio of the index.

If we look at the given chart we can see the difference between Observed P/E and True P/E. from 1995 – 2001 the observed P/E of the market is well below 20X but the true P/E of the index continues to trade between 20X to 40X.

Similarly from 2004 – 2008 the observed P/E of the market is between 10X to 22X while the true P/E ratio of the index moves from 13.7X to 47X

 Using true P/e instead of observable P/E ratio negates the impact of economic boom and bust on the EPS and helps us true gaze the the correct valaiton of the market.

This model is itself not without faults or criticizm. The primariy being

1.       The CAGR rate for the future may be different then the CAGR rate of the past but this can be adjusted in the model. I will use the long term infaltion expecations + long term GDP growth rate as future growth rate for EPS

2.       The current EPS which is used to calcuate CAGR may be subdued due to economic down trun or may be excessively high due to economic boom which in trun will impact the CAGR.

3.       The base EPS may be incorrect which will change the true P/E calcuation.

4.       Future market multiple can be significantly different from past market multiples.

All these are valid critisim of the model but they can be negated by using the model in a proper way which will take care of these limitations.

I have created a model using P/E ratio which can help a long term investor exploit the market swings between excessive fear and excessive optimism. I have assumed that the investor has the capability to switch from equity to debt when markets are richly valued and he can create leverage when markets are cheaply valued.

In the below table we can see median P/E multiple for the market

Valuation	Upper Range	Equity	Cash
Median	22.7	100%	0%
+1 Sigma	30.3	75%	25%
+2 Sigma	37.9	50%	50%
-1 Sigma	15.1	115%	-15%
-1.5 Sigma	11.3	130%	-30%

As per this model we will never go 100% in cash or take excessive leverage. We will increase exposure when markets are trading cheap and reduce exposure when the markets are trading at rich valuations. The base exposure of the portfolio is 100% if the market is trading between -1 Sigma median to + 1 Sigma median of True P/E i.e. between 15.1X to 30.3X. If the true P/E moves above 30.3X then reduce equity exposure to 75% and if true P/E moves above 37.9X we will reduce equity exposure to 50%.

Similarly when true P/E falls below 15.1X we will create a leverage of 15% and increase exposure to 115% and if true P/E falls to 11.3X we will increase our exposure to 130%

Conservative investors can avoid using leverage but they can increase the allocation to equity and reduce allocation to debt in their portfolio when market trades below 15.1X or 11.3X of true P/E. To reduce the frequent rebalancing of portfolio I prefer to use the average of last 5 quarters of true P/E to make allocation changes.

My average exposure to equity from 1979 - 2016 would have been 96%.  During market corrections i.e. from 30/12/1992 to 30/9/2001 when Index went sideways the exposure to equity would have been 71% while during the correction to 2007 – 2008 the exposure to equity would be 56%.

Hence if an investor follows this model to control his exposure in the market there can be substantial increase in the upside while reducing the volatility and drawdown at the same time.

Investors can change various parameters of this model according to their risk appetite. They can either be aggressive or conservative in managing their equity exposure.

In the first chart I have shown the equity exposure since 1979 and in the second chart I have shown the equity exposure from 1992 – 2002

 Equity exposure from 1979 - 2016

Equity exposure from 1992 -2009

I have also calculated the unlevered portfolio returns. The unlevered portfolio returns by using this method by simply allocating between cash and equity would be 18.1% CAGR compared to 16.3% for the index. Over a period of 37 years this would amount to almost 1.77X index returns with much lower drawdown and volatility.