Technical Analysis - a misunderstood topic by fundamental analysts

Technical Analysis is a much less understood subject by fundamental analysts. It is considered more of voodoo than being an art based on science of patterns and trends. Lets try and dispell some of the myths so technical analysis is treated more of a friend by most of the fundamental analyst community.

Technical analysis gives you a view to how other market participants have reacted to the stock in the past. This is an important data to understand and interpret as humans tend to react the same way in times of greed and fear and hence likely to repeat such behavior. In essence, a technical analyst believes that patterns repeat themselves and hence tries to find patterns in the stocks previous prices and volume charts and extrapolate the same in hte future. The basic tenet behind technical analysis is that human behavior is repeated whether it be greed or fear. Hence the knowledge of market behavior participants in the past gives you another data point to consider ascertaining the stocks future performance. Technical analyst is based on human behavior be it greed or fear and people tend to react in the same manner no matter what security or what time frame and hence the concept of symmetries and patterns.

There is a saying in the Indian market “bhaw bhagwan hain” meaning price is god. Prices by themselves convey a lot as is taught to us in basic economics. Technical analysts take it to the next level by looking at open, close, high and lows of a security in one day, one week or one month. By looking at patterns they can tell whether bears or bulls rule the market.
As is with fundamental analysis, it is more of an art than an exact science. For a fundamental analyst a P/E of 10 can mean overvalued as well as undervalued depending on where the market, the sector and the company has traded historically and his future expectations. Similarly for a technical analyst it is the subtle art of deciphering patterns and symmetries can make all the difference whether a particular stock is overvalued or undervalued.

The basic advantage that a fundamental analyst gets is to get a sense of the entry and exit levels of the stock.

A word of caution - Technical analysis does not work on illiquid stocks as in such stocks it is not the behavior of the masses but that of a select few that have more often than not insider information. Hence, technical analyst is most useful on liquid stocks.

Time for capital market participants to look at emerging markets more closely?

For the last 30 years, growth in financial assets was primarily driven by rapid increase in equities and private debt securities in countries such as United States, Japan and Europe. The world’s financial assets – including equities, private and public debt, and bank deposits rose from $11 trillion to $194 trillion, becoming four times the size of GDP.

The United States has the dominant share of the global financial markets with $50 trillion(385% of GDP) of assets. The eurozone is second, with nearly $40 trillion (314% of GDP). Japan ranks third with $26 trillion(533% of GDP) and the U.K. market has less than $8 trillion(325% of GDP) of financial assets. Asian financial markets remain fragmented and have very different characteristics. Japan has a huge government-debt market, whereas China holds 75% of its more than $12 trillion(270% of GDP) in financial assets as bank deposits. India's financial system is tiny, with only $2 trillion( 160% of GDP) in assets -- possibly ranking as the global dark horse in the decade to come.

However, after the 2008 downturn, the drivers of future growth have likely shifted. There is a growing consensus that going forward, growth in financial assets would be led by emerging markets such as China and India. There are primarily two reasons cited for this – one, the fundamentals support it; second, there is enough room for them to grow.

Equities have been the fastest growing asset class in mature markets since 1990, as corporate earnings and price earnings ratio increased. But now, earnings growth has slowed and valuations fallen. In developed markets, GDP growth is likely to more modest due to aging population and mounting government debt- little reason to believe that corporate earnings would grow, if at all from domestic growth. On the other hand, emerging economies will likely grow much faster on the back of better demographics and high savings rate. India alone would have 270mm net increase in working age population (almost the size of the US) and middle class would nearly quadruple from 22 mm to 90mm. Subsequently, consumer spending would increase by four times to $1.2 trillion by 2025. Secondly, these countries lack basic infrastructure and hence massive amounts of financing will be required to build them. India alone would need about $1.2 trillion capital investment to build its roads, metros and cities.

Thirdly, the growth of the equities will also be driven as more state owned enterprises are privatized and as existing companies expand. It is commonly believed that only about a fraction of the companies are listed in emerging markets, while about 70% of the companies’ trade on the exchanges in the US. Similarly the corporate bond markets and other private debt securities would grow with significant legal and financial reforms.

The third big factor contributing to the growth of financial assets would be bank deposits. Currently 2.8 bn people in emerging countries are unbanked. For instance in India, more than 50% of the household savings are pooled into hard assets such as housing and gold. Bank deposits would grow significantly as more of the unbanked are brought into the mainstream financial system. As more and more people open savings accounts and household savings grows, deposits would grow.

More importantly, if we compare the size of financial assets in terms of GDP, more commonly known as financial depth, most emerging markets are tiny compared to the US and other mature markets. The total value of all emerging market financial assets is equal to just 165 percent of GDP – just 145 percent if we exclude China – well below the 403 percent financial depth of mature economies. Clearly there is a lot of room for the assets of these economies to grow.

Clearly, all these factors combined would lead to substantial growth of financial assets in the emerging markets in the next twenty years; their relative share in the global capital markets would only gain further prominence. It is simply too glaring to be ignored any longer.

IMF raises India's target GDP growth to 9.5%, is it sustainable?

The IMF revised India's target GDP rate to 9.5% with many brokerage houses following suit. It also reported that growth would be largely consumption led . Clearly this is great news, where growth in US and China seems to be losing steam. But is the "largely consumption" led growth sustainable? Lets break down the numbers -
GDP growth has three components -
1. Due to Investment growth
2. Consumer spend
3. Net exports
In the case of US, where lot of core investment has already been made, the growth is largely consumption led. China is largerly export oriented economy and hence most of its growth is derived from exports and investments.
India differs from the two -
India has net negative exports and hence growth in India would be largely investment and consumption led. Also, since it is still a developing economy, investment growth forms a major component of GDP growth. Now, lets look at the two numbers broken down -
1. Investment - The investment to GDP growth is 34% which is quite good. However, this might largely be projects getting completed rather than new projects being started.
2. Consumption - In an economy such as India, where organized retail forms 4-5%, it is hard to track consumption growth. Consumption is tracked through quarterly GDP estimates - household expenditure. Secondly, we can use IIP data as a proxy. We break IIP data into consumer durables and consumer non-durables. Consumer goods data is very healthy at 6-7%, but if you further break it down - consumer durables is 20% and consumer non-durables is 2%. My index of sustainable consumer growth is non-durables growth. The reason being - consumer durable growth is driven by interest rates (one buys an automobile, as they feel interest rates might go up). Consumer non-durables is lifestyle augmentation - once you start consuming these, you can't really roll them back - they are not one-off purchases.

To maintain an 8-8.5% growth, we need consumption to grow at 6%. If you look at the historical pattern - it tends to lag and is more robust. Household consumption is also more stable than investment spending. When things go down, households preserve their consumption expenditure until their incomes start getting strained. On the way up, household expenditure does not go up all of a sudden, it gradually does. In the 2000 cycle, investment hit rock bottom in 2000, then gradually recovered by 2002, however consumption response to income growth came in late 2004 and gradually picked up in 2005.