After a very strong performance in September, markets were subdued in October and were down 1.5% for the month. For the current financial year, equity markets are up 6.1%. During October, our portfolios also corrected broadly in line with the market. Corporate earnings for the quarter ended September have broadly been weak, with even the consumer oriented companies showing weaker numbers. This is partly due to the delayed Diwali season, and more importantly due to the economy slowing down. The RBI continues to keep interest rates high, with the intent to address the persistent high inflation, and this has had an impact on economic growth.
For the last 3 years, the Indian equity market has been subdued, trading in a narrow range. An analysis of the Sensex’s trading pattern over the past 20 years shows that the annual volatility in the Sensex over the past 3 years has been among the lowest over this period. While there are many definitions of volatility, for the sake of simplicity we are taking the 52 week high low range to calculate volatility. If the Sensex were to trade between 10,000 and 16,000 in a given year, then by our measure the annual volatility of the Sensex for that year would be 60%. Over the last 20 years, the median annual volatility of the Sensex volatility is close to 60%. Volatility over the last 3 years has been averaging 32% and for the first 10 months of 2012, it is only 25%. History suggests that the market should break out of this period of low volatility one way or another.
The low volatility in the market is probably because of a lack of earnings momentum and poor investment sentiment on one side and low valuations on the other side. The lack of earnings momentum and all the negative news regarding the global economic environment, as well as policy issues in India, is not allowing the market to move higher. At the same time, we observe that after years of being in a narrow range, the valuations have become compressed and therefore all the negative news flow is unable to drive stock prices lower.
The last time that we observed this kind of compression of the market’s volatility was in the period 2001 to 2003, towards the fag end of the previous bear market. At the low point of 2012, at a Sensex level of 15,358, the market was trading at roughly 15x earnings which is also the median of the annual lows over the last 20 years. Add to this the fact that the earnings growth of the Sensex over the last 4 years is about 8% which is way below the trend line EPS growth of 15% over the last 20 years. All of this brings us to our thesis, that there is a higher probability that the breakout from this period of low volatility is likely to be to the upside rather than to the downside.
The stock market continues to present interesting opportunities from an investment point of view and we continue our efforts to buy into high quality companies at prices that are reasonable with respect to their growing intrinsic value.