Medium-term pain for Sensex

As earnings estimates are lowered, India may not be able to justify its premium valuations compared to other equity marekts.

At the end of the earnings season, it is now becoming apparent that the first quarter did not bring positive surprises. And the second quarter is unlikely to be any different. In fact, most brokerages are now coming up with new earnings estimates for FY12. Not surprising them that the Indian markets fell by more than 4 per cent last week, underperforming developed markets by 130 basis points and emerging markets by 470 basis points.

So what’s in store for Indian equities? Macquarie Equities Research says while markets are looking oversold, confidence levels remain extremely low. This may be a sign of a near bottoming, but investors seem to be in a dilemma —whether to buy costly defensives or bottomless beta — resulting in inaction.

Despite being in the over-sold bracket, the bottom is still far away, simply because Indian stocks are still trading at a 39 per cent premium compared to other emerging markets. MSCI India’s forward PE is 13.9x, compared to the MSCI EM’s forward PE of 10x. Global as well as emerging market (EM) fund managers believe that despite the recent correction, India remains expensive compared to peers. According to calculations done by Ambit Capital, India currently trades at an almost premium to the broader EM pack (on a forward PE basis) as opposed to the long term average of 25 per cent. In the current circumstances, this premium does not seem justified. Investors would find little reason to pay this kind of premium for Indian equities, as growth slows to a trickle, inflation rates remain higher than regional peers and political logjam to boot.

Ambit Capital had highlighted back in May that it expected the then consensus EPS estimate for the Sensex for FY12 of Rs 1257 to grind lower to Rs 1169 (implying a 7 per cent correction) on account of higher than anticipated interest costs (2 per cent impact), raw material costs (3 per cent impact) and employee costs (2 per cent impact). On 13 June, 2011 the brokerage further cut its EPS estimate further to Rs 1159. With GDP growth likely to come in below 8 per cent, consensus earnings estimates are veering downwards too. In a worst case scenario, which looks highly possible, the Sensex could touch 14,500 levels or thereabouts.