Market is going through a classic ?overreaction? phase

Over the last five years, Indian markets have witnessed three significant corrections?the first was triggered by the global financial crisis in 2008-09, followed by sustained downtrend all through 2011 led by domestic macro factors, and the recent correction in 2013. The YTD (year-to-date) fall of -7% in the benchmark indices is not reflecting the internals, wherein many stocks have corrected by 25-30%+ in a short span of three months.

The aversion to equities is reflected in retail inflow into equities. Over the last three years, FIIs have invested $80bn and domestic investors have redeemed $14bn. During the last 15months, FII inflows at $34bn were in contrast to large outflows by domestic institutional investors at $16bn. Market sentiment has tilted towards extreme pessimism and investors are either shunning equities, or adopting a defensive positioning.

The recent correction is triggered by concerns regarding slowdown in overall growth (particularly the investment cycle), current account deficit, sticky consumer price inflation, and caution ahead of the forthcoming elections. However, we need to segregate the cyclical issues and the structural issues. Also, are sufficient steps being taken to sort out some of the structural issues. In this context, we would like to highlight the following positives:

Long-awaited oil reforms: History suggests Indian government accelerate reforms during crisis. When pushed to the wall by the threat of rating downgrade, the government unleashed the much-delayed oil pricing reforms, which was the crux of high deficit, borrowing, and pressure on the interest rates. Diesel reforms will reduce the under-recovery by almost 50% to less than R90,000 crore by FY15 (as against R160,000 crore in FY13). Notwithstanding the short-term pain on inflation, these reforms are significant?they improve revenue to government, help curtail deficit, and improve market sentiments and disinvestment possibility.

Current account deficit?expect a multi-pronged attack: The latest current account deficit reading of 6.7% of GDP was alarming. Given the widespread impact of current account deficit on currency and investments, we expect a slew of reforms from the policymakers to reign in the deficit. Apart from discouraging gold imports, we expect measures to help attract foreign inflows, and also structurally address bottlenecks in manufacturing exports. Overall, even without any aggressive measures, we believe that there would be a gradual improvement in current account deficit over the course of 2013, owing to a pickup in global demand and stable commodity prices.

Subdued commodity prices: Given the anaemic growth in global markets, the prop to commodity prices in the past from quantitative easing is now increasingly waning. Stable to low prices of key commodities like oil, metals, etc., is a significant positive for India given the scale of imports.

Structural growth drivers: Rural growth drivers are still intact given the consumption nature of our economy. The problem is related to total drying up of investments, and urban-led slowdown in discretionary spending. For investments to kick start we would need more reforms from government, and as regards to consumption most of the demand drivers related to demographics, urbanisation, etc. are secular. There could be cyclicality arising from high inflation?however, as inflation stabilises, we would see discretionary spending picking up.

Valuations ? if it is in price, are we double-counting the worries? This is an important factor which many investors miss out. While valuing/buying businesses, we need to look at the ?price-value? gap, irrespective of the phase of market. During buoyant markets, typically near-term assumptions (of high growth, margins, lower discount rate, etc.) are extrapolated, which leads to an increase in value and the stock prices also move in tandem. At the other extreme, during sluggish markets, the underlying assumptions may result in lower valuation and the stock price also corrects?the moot point is that ?price value equation? may be similar, and in fact invariably favourable in bear markets. The key is to assess the long-term value of businesses and stick to quality companies. Another way to gauge the valuation gap is to compare the valuation of listed company with the ongoing deals of similar businesses in the unlisted space. Various deals during the last few years across sectors point to a multiple difference in valuation with the listed space lower by a significant margin.

Indian markets are going through a classic ?overreaction? phase. The overreaction hypothesis states that investors react irrationally to events by placing too much weight on current events. Although overreaction pushes stock prices abnormally high or low in the short to medium term, they adjust to the intrinsic worth in the long term.

At the current juncture, a lot of the negatives are factored in the valuation of Indian stocks, which on an aggregate basis are trading at about 30% lower than long-term averages. One measure is the current low price to earnings multiple (P/E) of 13x forward earnings is particularly attractive, as ?E? (earnings) is depressed owing to headwinds. Adjusted for retained earnings, many decent businesses (say with return on investment above 20%) are quoting at near their all-time lows.

Sustained market declines can be unsettling. However, it is important to realise that market declines are cyclical and thus natural. Many a times the action required is ?nothing? i.e. simply following a well-disciplined asset allocation with planned diversification. For Indian markets, reversion to mean, has taken longer during the current phase owing to multiple headwinds. We however expect meaningful returns to investors with patience as mean reversion would happen with respect to growth, earnings, valuation, and flow in equities.

The author is Head Equity, Mirae Asset Global Investments