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Pain is likely to continue in short term

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with a horizon of 2-3 years may see some gains from current levels.

The emergence of an was inevitable, given so many other scams in so many other sectors. Every scam has a negative effect on stock prices as and when it comes to light. The mood as 2012 begins, is therefore, pretty sombre.

Unfortunately, valuations don’t reflect the extremely negative sentiment and poor fundamentals. The market has fallen 24 per cent in the past 13 months. That leaves the trading at a PE of 17, in terms of weighted, standalone earnings of the past four quarters as per methodology.

By my reckoning, this is still well above fair-value in terms of two broad measures. One is the comparison between the return from a risk-free instrument and the expected return from equity. The other is the .

Equity is good value when the earnings yield (the inverse of PE) is higher than, or equal to, the yield from risk-free debt. The yield on a one-year is currently 8.4 per cent. It’s 8.5 per cent for the 10-year Government Security. This is roughly equivalent to a of 12-13 and it’s quite a distance below current valuations.

Using the metric of PE divided by earnings growth rate, equity investments are fair-value if the PEG is close to 1. A conservative investor would seek PEG ratios lower than 1. Over the last four quarters, the Nifty’s weighted earnings grew at 10 per cent (NSE methodology). The six-year Nifty earnings is 9 per cent. The PEG is above 1 with respect to both near-term earnings growth and long-term CAGR. Given the slowdown, earnings growth is unlikely to accelerate much in the next two quarters.

There is a collective cognitive bias that makes it difficult to accept a market is overvalued, even after a 24 per cent correction over 13 months. This is because the past six years included two bull runs - 2006-2007 and 2009-2010 - when valuations zoomed sky-high, due to excessive liquidity.

This was a global phenomenon with India a leading beneficiary. That led to huge value-inflation.

As mentioned above, the Nifty’s earnings CAGR has been just 9 per cent since 2006. This is hardly inspiring. In fact, there was a period in calendar 2009 when earnings declined year-on-year for the Nifty basket, due to the then-prevailing slowdown and base effects.

However, through 2006-2011, the average PE stayed at 20-plus, despite two long periods of bearishness in 2008 and 2011. Not only does this indicate a pattern of consistent over-valuation with respect to the PEG, it is also far higher than the 10-year average Nifty PE of 17.

If the investor overcomes the cognitive biases caused by that phase of extraordinary liquidity, he will recognise long-term valuations remain stretched in 2012, despite the correction through 2011. What is more, there is a global deleveraging in progress, implying liquidity will remain tight.

and his guru, , propagated the theory of reflexivity, wherein price trends never end at fair-value. During bull runs, markets get highly over-valued before they peak and during bearish phases, markets get highly under-valued before they bottom. If reflexivity holds true, and it usually has, there could be a big downside.

None of this is comforting for the short-term. You may well get an acceptable upside from current levels, if you invest with a two-three year perspective. But you would certainly have to contend with the prospect of a big downside within the next 6-9 months. If you want to buy at 4600-plus, be prepared to average down and that too, quite heavily.

What would be potentially safe entry points with the Nifty at fair value or lower? At the bottom of the 2008 bear market, the PE slid below 11. It remained below 12 for an extended period. A bottom-fisher may hope for similar low valuations in 2012, assuming no fiscal policy action and no rate cuts. You can also envisage scenarios where the cut rates by say, 100-150 basis points inside the next 6-9 months.

Factor in earnings growth at somewhere between 0-10 per cent. No policy action (and very nominal rate cuts) plus 10 per cent earning growth implies fair value at PE 12-13, which translates to Nifty levels of 3600-3800 over the next three quarters.

Rate cuts (and policy action) could push fair-value to PE 14-15 in the same timeframe. That would translate to Nifty levels of between 4100-4300 in the next 6-9 months.In the worst case, if earnings are flat or negative, there is no policy action and the RBI doesn’t cut, we could be looking at 3200 before the bottom is visible.

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