Has the market bottomed out? 4 factors that will confirm it

There are many developments recently, which suggests inflation may be peaking. In its latest research note, Kotak Institutional Equities said inflation remains the key variable for global and domestic markets and any signs of easing in inflation will likely provide a cap to bond yields and a bottom to markets.

Kotak said the recent economic data has raised hopes of a peaking-inflation scenario playing out versus the more draconian rising-inflation scenario, the former will see moderate rate increases by the RBI, the latter drastic measures. Here's what it said.

1) Monsoon revival
Kotak said a revival in monsoons over the last fortnight after a late start has raised hopes of a normal monsoon, in line with the forecasts of India’s met department. High food inflation has been one of the drivers of overall inflation over the past few months. However, the bulk of inflation is largely due to seasonal items such as fruits and vegetables and a good crop output in the next season will hopefully bring down prices while keeping prices of food-grains and other food items in check.

2) Commodity price correction
The brokerage noted that a collapse in metal prices and moderation in crude prices over the past month may help keep inflation in check over the next few months assuming prices do not spike again. The sharp price declines in commodities reflect growing concerns about a recession in the EU and the US in 2023, it said.

"A mild recession in DM countries need not be bad for India as it will result in softer commodity prices and lower imported inflation. WPI inflation has been at very high levels in India for a while pushed up by higher commodity prices, which in turn has fed into CPI inflation through higher prices of manufactured goods. Nonetheless, upside risks to inflation remain, especially from higher fuel prices led by possible further decline in Russia’s energy supplies, forced by retaliatory actions of both the EU and Russia," Kotak said.

3) All that matters is valuations
While there have been concerns over relentless FPI selling, valuations have become attractive, which will sooner or later lead to recovery in the market.

The market at any point in time simply reflects the combined wisdom of all market participants—as of now, it is the negative view of FPIs versus the positive view of retail investors, Kotak said.

"Flows could change on expectations about the future at any time. Thus, it is much more useful to focus on valuations. As of now, broad market valuations are still not attractive enough in the context of bond yields and bottom-up valuations," it said.

4) Lower bond yields
The current high yield gap between bonds and equities is making equities look a bit unattractive. There are four ways this gap can be narrowed.

One is if bond yields fall, which is unlikely in the context of current high inflation and government finances. Kotak said inflation would have to drop sharply for bond yields to come off.

A way to narrow the yields between bonds and equities is higher earnings, which also seems unlikely in the current macro-environment.

It can also happen if earnings yield rise over time, i.e. time correction, "which is a high-probability event corresponding to our peaking-inflation scenario. Lastly, higher earnings yields through a correction in the market (price correction), is also a reasonably high-profitability event linked to our rising-inflation scenario," Kotak said.

Kotak said a period of in-line inflation data will help stabilize the market and a period of time correction will help close the yield gap. The market would need to correct to 16.8 times 1-year forward P/E multiple through time correction or fall to the same level through price correction for market multiples to bottom.

"We assume a 150 bps gap between bond and earnings yield as a good place for the market to find support," it said.

(Disclaimer: Recommendations, suggestions, views, and opinions given by the experts are their own. These do not represent the views of Economic Times)