2010: A gamble in equities

Valuations can look stretched if the momentum in recovery doesn’t pick up as expected.

New Year is a convenient time to review return expectations. Betting on equity in 2010 will be a gamble despite a high probability of strong earnings per share (EPS) growth. We can very roughly quantify what it requires for the gamble to succeed.

The Indian markets hit record highs in January 2008 and then crash by by over 50 per cent in calendar year 2008. Then there was a great recovery. At the end of a two year roller-coaster ride, the Nifty is about 20 per cent below its record peak of 2008.

Long periods of negative returns are common in equity markets. They are generally balanced off by longer periods of gains. For instance, between May 2003 and January 2008 the Nifty rose by over 300 per cent.

Note that the EPS growth was modest till September 2008 but the stock market crash came in January 2008. The price recovery started in March-April 2009, though, EPS recovery is only being signalled by the most recent July-September 2009 quarterly results. Crash and recovery preceded fundamentals by many months.

The fundamentals look good heading into 2010. But that doesn't necessarily mean a great year for investors. The good news has been anticipated by rising prices. If the recovery doesn't pick up a lot of momentum in 2010-11, valuations will be very stretched.

The Nifty is at 23 price-to-earnigs (PE) ratio (last four quarters earnings weighted by market capitalisation) according to the National Stock Exchange (NSE) data. The EPS growth for Nifty is negative. The Nifty EPS in September 2009 (224) was down as against September 2008 EPS (228) and almost flat as compared to September 2007 EPS (223). Given inflation, EPS growth has been negative for two years.

It's pertinent to note that September 2009 EPS (224) was up 6.3 per cent (non-annualised) over March 2009. To justify 23 PE, EPS growth through the next four quarters must match or exceed 23 to stay with the rule of thumb of PE:EPS growth (PEG) ratio of less than 1.

For example, we're hoping for 25 per cent EPS growth - September 2010 EPS is expected at 280. Are we likely to see so much EPS growth? Well, there is a relationship between gross domestic product (GDP) trends and EPS. EPS growth of ten exceeds GDP growth. The relationship isn't linear since inflation comes into the picture. GDP numbers are post-inflation, EPS is inflation-unadjusted.

Modelling this is complex and controversial. But we can say the highest spikes in EPS growth occur when inflation is moderate while GDP growth is high. For instance, EPS grew 24 per cent in 2006-07, when GDP was at 9.2 per cent, while wholesale price index (WPI) ran at 5.5 per cent. In 2007-08, GDP decelerated to 9 per cent (still impressive) while WPI was 4.7 per cent and EPS was up 11 per cent. Last fiscal (2008-09), GDP decelerated to about 7 per cent while inflation was 8.3 per cent and EPS declined to 8 per cent.

In the past 9 months, inflation is up at about 5 per cent over March 2009 levels, GDP growth is between 6.5-7 per cent and September 2009 EPS was up 6 per cent. The full fiscal estimates for 2009-10 suggest inflation will be in the 5 per cent zone for the year while GDP will be 7-7.5 per cent. EPS growth should be positive given the past 6-month trend.

Will it be positive enough? Breaking up the September 2009 target, we are hoping for March 2010 EPS of 240-245 and a further climb to 280 by September 2010. That means around 15 per cent EPS growth in 2009-10 over 2008-09 and another 15 per cent growth (non-annualised) in the first half of 2010-11 over March 2010.

Assuming the GDP estimates are reasonable and inflation doesn't climb beyond 6.5-7 per cent, these numbers are credible. The market thinks so, given the steady advance of stock prices. Hence, the gamble of staying broadly invested in equity seems justified.

The numbers look very exact but there are enormous error-margins built into all of these components. These are actually very crude projections, though they are based on the most credible estimates available.

Any of the variables projected may be wrong and wrong by magnitude. Inflation could climb, GDP growth may slow, corporate EPS may not respond as positively as we hope to strong GDP growth. Bear those factors in mind as you head into 2010 and keep your fingers crossed.