Have stocks hit the cheap zone?

Not yet. Valuations only appear attractive, but if one factors in earnings downgrades for next year, then market P/E loses sheen

Everytime the market’s one year forward price/earnings multiple dips below its 10 year average of 14x, the pundits rise to say buy. But in the current context this advise could prove to be dangerous as the worst is not over for the markets. 

 

There are too many variables at work right now. For starter, the foreign institutional sell off is not yet over. FII flows over the last three months have been negative. However, despite the sharp fall in the rupee, the markets have not seen very heavy selling. But the risks are still not factored in yet. India’s equity market has not been the worst performer despite the rupee’s fall and other structural issues. That experts say is because FIIs own nearly 45% of the freefloat and 22% of the listed universe. However, this does not mean that they will not sell. 

 

During tough global conditions Indian equities tend to go down to 10x one year forward earnings multiple. The current situation is nowhere near that. With the rupee’s fall and oil prices rising, the stress is only expected increase on the government’s finances. In the first quarter of the fiscal itself, 55% of the government’s fiscal deficit target has been reached. Given that it is a pre-election year, spending cuts won’t happen this year like last. This means that fiscal prudence may fly out of the window.  

 

However, things could definitely go there. 

 

Valuations look attractive now as the forward estimates are more optimistic than reality. Once the downgrades are factored in the valuation will appear fair and close to the 10-year average. Downgrades for next year have not yet started but sense will prevail as too much optimism has been built around forward earnings. Based on analyst estimates,the EPS of Sensexis expected to be Rs1305 in FY14 and Rs 1540 in FY15. Bank of America Merrill Lynch expects to be downgraded to Rs 1260 and Rs 1400 respectively.

 

In times of a global crisis, forward PE of the Sensex goes to 10x, however, given that the developed world is recovering, analysts expects the forward PE to touch 11.5x in the worst case scenario. Based on this, Bank of America Merrill Lynch believes in the worst case scenario, the Sensex could go down to 16,000 points.