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*Predictions for Dow *
*Sunil Kewalramani * Advertisement
Only a year ago, the stock market was like a laid-back surfer, cruising the
shallow dips and peaks. Having become increasingly erratic since the summer
of 2007; it has now morphed into a full-fledged, wild-eyed base jumper.
Currently, the Price-Earnings Ratio, one of the most basic parameters of
equity valuation, is at its lowest level in many years for many of the
leading markets.
I believe that the fair value of the Dow currently is around 14,000 (based
on current earnings, which have been slaughtered for some important Dow
components), and it is trading at about a 10 per cent discount to fair
value. Using a 9 per cent cost of equity, the recent correction in the Dow
may be more than fundamentals should allow. I believe that it needs to play
catch-up and reach its fair value of 18,000 (increasing earnings is easier
on a low base) by end-May 2009.
Financial companies have just absorbed huge write-downs and after some more
bloodshed over the months to August 2008, a powerful Fall 2008 rally
(commencing September 2008) in Dow components appears to be on the cards.
When we compound the Dow's closing value of 12,400 on April 14, 2008, by an
8 per cent annualised price return ; after accounting for the correction and
the sharp rise expected in the earnings numbers from here, we arrive at an
index level of 18,000 for the Dow by May 2009. During this period, we are
likely to see an across-the-board global rally in stocks with most sectors
participating. Here are a few reasons that back this prediction:
*Oil money*: Even if we take a conservative $100 as the average price for
crude oil, we are talking of $2 trillion worth of foreign exchange reserves
being generated this year for oil producing countries. A maximum 10 per cent
of this can be invested in the local economies, if they have to achieve a
GDP growth rate of 10 per cent without over-heating their respective
economies.
This means that $1.8 trillion worth of additional liquidity is expected to
be generated in the world over the next year or so. By all estimates,
whatever the losses of US sub-prime mess (which some say will be in the
neighbourhood of $3 to 4.5 billion — equivalent to about three months of oil
selling), the incremental liquidity of $1.8 trillion should flow into world
markets.
The rush of liquidity could be positive for equity, may help it regain
favour. The failure of a big Wall Street institution often signals a market
bottom. That was broadly true of Continental Illinois in 1984; Drexel
Burnham Lambert in 1990, Kidder Peabody in 1994 and Long-Term Capital
Management in 1998. According to JP Morgan, the S&P was up an average of 17
per cent in the 12 months after these events. *Credit crisis will not be
cataclysmic:* By beginning fall of 2008, the very low federal funds rate
will bring down 10-year rates, helping mortgage refinancing take off.
The resultant steeper yield curve will boost the profitability of banks.
Also, I believe the US Treasury will shortly begin defending the dollar in
an almost 1985-like situation where yen had climbed up to 85 to a dollar.
Paul Vocker, then Fed Chairman, had let some shorts build up, and even with
small US treasury intervention, the dollar climbed, as knockout options got
triggered.
There is also the argument that a great unwinding of the commodities bubble
is in the offing over the next six months. *Greenback to recoup*: America's
return to a solid rate of growth with acceptable inflation and low interest
rates will cause a dollar rise. Unwinding of carry-trades is also expected.
Speculators have been making money borrowing dollar at low rates, buying
pounds and investing them at higher rates. A reversal of this trend will
cause speculators to sell Euros and pounds and rush to buy dollars in order
to repay their dollar loans, thus boosting the US dollar and US stock market
values. An increase in Cross-Border Mergers and Acquisitions, as various
companies in the emerging economies find American companies available at
distress sale prices, could also stoke a rush for US dollars. *
Equity yields 50 per cent higher than bond yields: There is no credit crunch
for large companies. Triple-A-rated companies can borrow at lower rates than
they could a year ago. Both US and non-US public companies will continue to
borrow money to buy their own shares, or to take over weaker competitors,
thus enhancing global asset and stock prices. Though there is indeed less
credit available for speculators, I do not believe there is a 'credit
crisis' in the strict sense of the word. But arms are open for companies
with sensible business propositions and sound investment plans. It is
surprising to see that even at the sub-prime end, debt rated AAA, the yield
is down from 5.18 per cent to 4.63 per cent. If this was a real credit
crisis, the rates would have shot through the roof. We are not witnessing a
'negative feedback loop' in which tighter liquidity conditions, lower asset
prices, impaired capital resources and reduced credit supply prevail;
because the US Fed is pumping liquidity into the system.
Now for the argument that China will slow down if a recession strikes in the
US, because more than half of China's GDP consists of exports. I would like
to point that China and India have embarked on a high growth path of
infrastructure development and after the de-leveraging in the commodities
arena is over, we will once again witness good demand for commodities from
these two growth engines.
Since there is a gestation period before the monetary stimulus of the
central banks generates inflation, inflation may return by summer-2009, with
a Goldilocks scenario until then. If the powers that be do forestall
deflation or a bad recession, the cost is likely to be inflation.
Expect a downfall
A movement in financial markets from over-exuberance to excess pessimism
always creates great investment opportunities, just as in the present stock
market scene.
The Dow, along with other world equity markets, has retraced substantial
lost ground during March-April 2008. A mid-way turbulence during June 2008
through August 2008 is expected. In this period, surviving banks will have
experienced a chastening shock and will continue to give priority to
restoring their credit buffers, so credit will be restricted till August
2008.
The near-term risk-reward trade-off for equities has deteriorated. Emerging
market equity valuations have also returned close to long-term averages,
during the rebound. Earnings revisions have deteriorated, suggesting
moderate downside risk to consensus earnings expectations for 2008. All this
points to a painful summer on Wall Street (June-August 2008).
Powerful Fall equity rally round the corner
Thereafter, I expect a strong fall rally beginning September 2008 which
should take the Dow right up to 18,000 as the uncertainty over the US
Presidential election ends and the effects of the monetary policy easing by
Ben Bernanke and his team begin to translate into higher growth numbers.
Most stock market analysts will be busy downgrading their earnings estimates
for companies for most of 2008. Yet, I expect a powerful stock market rally
to emerge from September 2008 since at previous inflection points in global
equity markets, stocks often rallied six months before analysts were done
with the downgrading process.
Re-emergence of Goldilocks scenario: September 2008-May 2009
I anticipate a V-shaped earnings growth chart in 2008, a sharp drop followed
by a vigorous bounce back in the Fall of 2008 and extending right up to
end-May 2009, as the good effects of Fed easing start getting reflected in
headline numbers. Eventually, the rise in the Dow will lead to a favourable
investment environment across the globe. Whether or not China and India have
decoupled from the developed world from an economic standpoint, there is
little doubt that the world of finance is very much coupled, and as Wall
Street catapults into new unchartered territory; so will Canary Wharf and
Dalal Street, as well as the rest of the world!
(The author is CEO, Sunil Kewalramani Global Capital Advisors and can be
reached at globalequity@sunilkewalramani. com. Views expressed are
personal.) *
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IMPORTANT DISCLAIMER Investment in equity shares has its own risks. Sincere
efforts have been made to present the right investment perspective.The
information contained herein discussion is based on analysis and up on
sources that we consider reliable. I, however, do not vouch for the accuracy
or the completeness thereof. This material is for personal information and I
am not responsible for any loss incurred based upon it.& take no
responsibility whatsoever for any financial profits or loss which may arise
from the recommendations above.
[Non-text portions of this message have been removed]
Rohit
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