More positives than negatives for stock markets

Index is upgraded with optimistic 'bull case' by Morgan Stanley computed at 39k by end-December 2017

The Sensex is trading at a current price to earnings ratio or P/E (last four quarters, weighted by free float) of 22.7 and a forward one-year P/E of 18.2. The forward P/E is estimated of course. At an index value of 31,110, we can calculate backwards to derive a current EPS of Rs 1,371 and a forward EPS of Rs 1,710. This implies that the Sensex is expected to see EPS growth of about 24.5 per cent in this financial year.

Is this historically likely? The 30-share index has an annual growth of 6.7 per cent since 2010 and an annual growth of 10.4 per cent since 2000. But, the Sensex has experienced year-on-year EPS growth of 25 per cent at least four times in the 21st century. So it's certainly not impossible.

The last time it happened was in financial year 2009-10, when the index earnings per share jumped 40 per cent, as the global economy recovered from the sub-prime financial crisis. The other times were in the 2003-2007 period when macro-economic growth was excellent, during the longest, most rewarding bull market in India's history.

The latest results reinforce the optimism. Of the Sensex components, consensus price targets for 23 out of 30 companies have been upgraded according to Bloomberg's compilation of price targets released by various investment houses and analysts. In fact, every sector except information technology and pharma have seen upgrades. The index itself has also been upgraded with the optimistic "bull case" by Morgan Stanley computed at 39,000 by end-December 2017. That's roughly 25 per cent upside in the next seven months.

Apart from expectations of an uptick in consumption, analysts are betting on the commodity cycle staying in a sweet spot even as the global economy picks up steam. Indeed, China (which is a good proxy for the global economy) and Europe are both showing strength while the US is chugging along.

Metals, coal, natural gas and petroleum prices are expected to remain stable or to see some gains. As of now, metals are expected to rise, moving up from multi-year lows. But, there is expectation of a ceiling on fuel prices.  

This is perfect for India. Rising metal prices are good for Tata Steel, Hindalco, Vedanta, Sail, Nalco, etc. Rising gas and petroleum prices could have a negative impact so price ceilings on fuels would favour India. ONGC gains as a primary producer if prices rise. 

But, the government is capable of forcing ONGC to share in downstream subsidies if fuel prices rise too much. Similarly, Coal India should gain from higher coal prices. But, it could get hurt since many of its clients (the state electricity companies) are not financially stable or capable of paying higher coal prices. Reliance Industries gains if refining margins improve, which is rarely associated with rising gas and petroleum prices.

What could go wrong with expectations of mass upgrades? These valuations are built on high liquidity and moreover, FII-driven liquidity. Hopes of higher growth are built on projections of sustained consumer confidence. That means problems if liquidity disappears, or if consumers lose confidence.

Everybody seems to believe economic growth will continue to accelerate, not just in India but across the world. Given protectionist noises from America, this may not be the case. Some event somewhere outside India could lead to a sudden drop in liquidity if it spooks the FIIs. Similarly India's tensions with Pakistan could lead to an eyeball-to-eyeball situation and a sudden market crash.

Finally, consumer confidence can change quickly and unpredictably. One of the pillars is employment - consumers are more confident when they feel secure about current and future income generation prospects. Given low job creation, it's an open question how consumer confidence will be sustained.