The Ostrich May Yet Have a Point

The talk of a financial Armageddon which took hold earlier this year seems to have vanished. The attention now is focussed on the extent and timing of the recovery in developed markets. Germany and France are back on terra firma with positive GDP growth in the latest quarter. The good news in the US is that the economy shrank just 1 percent in the quarter ended June 2009 as compared to a 6.4 percent drop in the previous quarter.

Stock markets around the world have been quick to recognise what appears to be a momentous inflection point. Not only have the markets climbed a “wall of worry”, the mood of investors across the globe is definitely more optimistic. The recent cover of BusinessWeek with an ostrich peeking out of the sand is a subtle parody on nay-sayers. Given the almost perfectly inverted predictive value of magazine covers in the past, time for a deep breath?

Behavioural economists have long grappled with the consequences of “optimism bias”, also commonly known as the “positivity illusion”. Human nature is such that it tends to over-estimate the likelihood of positive outcomes but conversely, assumes the odds of unfavourable outcomes to be lower than they should be. The consequences of this for the individual and society may well be at variance! More often than not, the price an individual pays for getting the downside risk wrong is a financial catastrophe. Yet a capitalist society benefits vastly from a culture of risk-taking.

True, there is a fair bit of evidence that the global economy is on the mend. The US housing market is showing signs of stability.

The grip of unemployment in the Western world is easing. The rise in commodity prices, the unrelenting decline in the VIX index (which measures volatility in options) to sub-25 levels and the greatly reduced spread between LIBOR and risk-free rates must bring cheer to the bulls.

Many companies were quick to use the knife once they saw the dark side of the recession in the last quarter of 2008. The flip side of that knee jerk response is partly visible now in terms of rising inventories and a revival in capital spending.

Corporate earnings, despite being mixed, have seen neither margins collapse nor volumes buckle. Quite apart from the resilience in fundamentals, the ascent of China amid all the gloom has been a major cause for the renewed optimism. The Shanghai Composite, rather like Atlas, has carried the world on its shoulders. But the ability to sustain amazing growth in this harried environment may prove too much even for the Chinese. For those in denial, the 32 percent decline in the current account surplus for the first half of 2009 and the 18 percent hit to aggregate corporate earnings last quarter are like a jab to the solar plexus!

Much like the efficient market hypothesis, capital asset pricing model, the Modigliani Miller theorem and other such drivel, the overwhelming majority of investors are wedded to the belief that a rising stock market is a harbinger of lasting economic recovery. If only it were so simple and
dependable.

“More often than not, equity markets are propelled by “animal spirits”, herd behaviour and constantly changing perceptions of “relative value”. Fundamentals do matter, but the power of capital flows is far more dramatic in the short term. So what are the implications for committing capital given the current mindset?

It is quite possible that the improving sentiment has a beneficial impact on the real economy in terms of a greater propensity for capital spending by India Inc. and higher levels of consumer spending. Keep in mind that the current government is eager to protect the financial well-being of rural India.

Given these circumstances, VST Tillers & Tractors (Rs. 385) is a compelling buy. The stock trades at under six times current year earnings, has consistently achieved sales growth of 25 percent in the last six quarters and sports a return on equity in the high 30s! Surely, enough reason to be ebullient about the stock even if it is harder to justify for the markets as a whole.