Signs of bull market, time to shift to cyclicals By RIDHAM DESAI, MORGAN STANLEY Indian cyclicals look ultra cheap relative to defensives. The decisive policy action at home (reduction in subsidies and opening up of FDI) and, more crucially, concerted action by the European and US central banks have reduced India’s tail risk linked to poor macro stability (twin deficit). Our preference for quality cyclicals is already expressed in our Focus List. We now put money to work on cyclicals in our sector model portfolio. Accordingly, we go underweight on consumer staples and raise energy and materials to overweight, as well as taking industrials to neutral. We are also trimming technology by 100 bps. Consequently, our average sector position has expanded, and we see this as our emerging strategy, as the average correlations of stocks to the market appear to be falling and no longer merits extreme focus on stock picking. We are expecting Sensex earnings growth at 10 per cent and 19 per cent in F2013 and F2014. Significantly, broad market earnings may have troughed or could trough in the current quarter. We have seen M1 growth put in a firm base in and revenue growth should slowly accelerate in the coming months. Margins could rise in the coming months with a favorable base effect driven by the relative movement in the current and fiscal deficit. Interest rates are already down YoY, and that should stem the steep rise witnessed in interest costs in the previous 12 months. The risk to earnings is that the investment rate collapses, although recent signals suggest that the public sector is starting to spend money. We roll our market target to Dec-13. Our target of 23,069 implies that the market will be trading at 14.9 times our F2014e Sensex earnings in December 2013. New bull market? Conditions for a new bull market are getting slowly satisfied. The yield curve has stopped flattening, liquidity is improving, valuations appear supportive and profit margin expansion is a growing possibility in the coming months. The market is likely to form a new base with positive developments on domestic policy. Key risks are that commodity prices rise quickly, bringing inflation pressures to the fore, and/or global risk appetite wanes as global policy makers slip into another cycle of complacency. Mid-term polls are also a possibility, but we do not necessarily see that as a downside risk to equities.