Of the three factors that move the market - earnings, valuation and sentiment - only one is somewhat in favour going into 2012
Where is the market headed in 2012? Year-end is an arbitrary point in time, which markets don’t respect. Stock market moves are mainly caused by one factor: corporate earnings. How much and how long a market move lasts depends on two other factors: the relative value of assets, and sentiment. If we tot up the score on these three counts – earnings, value and sentiment, as we end 2011 – what do we get? It’s 1/3.
Earnings growth: poor
At the time of writing this piece, Indian companies are not showing much earnings growth, nor are there too many factors that could accelerate that growth. And it has been so for quite a while. For much of early 2011, the consensus earnings estimate of (extraordinarily overpaid) analysts for 2012 of the 30 stocks in Sensex was around Rs 1,250 per share. The more optimistic ones pencilled in Rs 1,280. From April onwards, I have been suggesting that this was too optimistic. In June 2011, I wondered on our website: “Big brokers are reluctantly lowering their earnings growth target, leading to the belief that the market is undervalued. Is it based on false premises?”·
At that stage, there was little clarity among market participants about market valuation. Retail investors, who are denied sceptical voices by the media, were fed with persistent propaganda that the market was undervalued. The typical argument went as follows. “The Sensex EPS for 2012 is Rs 1,250. The Sensex is currently at 18,500. This means a forward P/E of just 14.8 — an undervalued market.” The math looked attractive except that it didn’t in real life: nobody was buying. The market remained sideways for months. For instance, in November last year, the low was 18,954. In end-July, the high was 18,944. More importantly, every rally was being met with more selling. Analysts kept on reminding us that only on a few occasions in the past has the forward price-to-earnings ratio (P/E) been about 14, and on those occasions, long-term buyers have swooped in. So why not this time? Because savvy investors probably didn’t believe the analysts’ bullish propaganda. There was an alternative math.
To start with, the 2012 estimate for earnings per share (EPS) was abnormally bullish. In 2010-11, a robust period of recovery, the Sensex EPS was perhaps Rs 1,013 (it is hard to agree on these EPS figures because the Bombay Stock Exchange calculates them in its own way, as does each broking house.) In June, the Bloomberg consensus estimate was Rs 1,240. This meant an assumed rise in net profit of 22 per cent. Was that logical, given that in a great year (2010-11), the Sensex EPS rose by 21 per cent? In fact, the performance of the Sensex companies in March 2011 was terrible. (And not surprisingly, the analysts had missed it by a mile. March quarter EPS growth was flat, while the estimate was of 17 or 18 per cent growth!)
Even after this, the analysts made a half-hearted downgrade – just three or four per cent – to the 2011-12 earnings estimate. Some estimates (Bank of America, Macquarie, and Citi) were ridiculously bullish at Rs 1,250. But even a Sensex EPS estimate of Rs 1,200 meant assumed growth of 18 or 19 per cent. Since the Sensex companies had done badly in the March quarter without any plausible reason and warning, it was prudent to work with pessimistic assumptions, not optimistic ones.
We suggested an EPS of Rs 1,150 for 2012, which did not make the Sensex look undervalued. In fact, at a likely profit growth of 10 per cent, EPS would be Rs 1,120. If this came true, for the Sensex to have a forward P/E of 14, it would have to be around 16,000. Not surprisingly, that is where the Sensex is.
That takes us to the second factor. At an EPS of Rs 1,120 and Sensex of 15,500, the P/E is 13.8. This is undervalued territory. But there is a problem. At a P/E of 13.8, earnings yield (the reverse of P/E) is 7.2 per cent. Safe fixed income instruments fetch nine per cent. Fixed income has to be less attractive for equities to be more attractive. This is precisely the reason US markets have done better than India’s over 2011. It may seem surprising but Dow and S&P are actually up in 2011 despite all the problems in developed markets, and this is partly due to extremely low interest rate set by the US Fed.
This is obvious now but market sentiment can turn on a dime. At any time, there are many more bulls than bears, and it takes only a little bit for them to herd together and charge ahead. But apparently, we have a deeper problem here. The poor sentiment is not just about corporate performance, but also about Delhi. Even seasoned investors are tired of “lack of reforms” and “poor governance”. But I am not sure this would be an impediment to a significant market rally in 2012. For instance, from early December 1996, the Sensex rallied more than 60 per cent till August 1997, on some hope or the other. It fell after the Asian crisis but rallied again 45 per cent from December 1998 to April 1999, on another set of misplaced hopes. After a deep decline, investors only need the flimsiest of excuses to buy.
To sum up, if earnings seem to be improving and/or interest rates come down, we will have a significant rally. After all, it is not “reforms” or governance that caused the Sensex to rise 80 per cent in 2003. Sentiment could improve if Delhi turns reformist — or worse, with fresh economic bad news.
Meanwhile, markets have always fooled those who soak up anecdotal evidence of doom or boom peddled by the popular media, and then try to link them to future market moves. Once something has been in the popular media for a while, it is no longer a surprise, and therefore loses the power to move markets. Market-moving signals, as usual, would again come out of one or more of these three factors mentioned above as 2012 unfolds. The rest would be noise.
The writer is the editor and publisher of www.moneylife.in. email@example.com
In spite of the RBI's rate cut and the Centre's reforms, any recovery will only be half-hearted