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‘Will this rally last or are we close to the top?’ That is one the biggest concerns of an investor in the market after a 30% run over the past six months. Though the equities markets touching new highs, the volumes, at least in the cash segment, are not as high as in earlier cases, suggesting investor apprehension in the rally. History is always a good guide, so one way of testing where we are in the bull run is to compare the present scenario with similar events earlier.
Broking firm Jefferies has looked at two previous economic recoveries to see where we are in the present rally. Jefferies concludes that the ongoing re-rating driven market rally is similar to historical rallies and likely to transform to one driven by earnings upgrades going forward.
The sharp rise in the market has resulted in 12 month price-to-earnings (PE) ratio moving from 13.5x to 16.8x during the period, a 24% increase. According to Jefferies, the economic cycle started turning as far back as January 2014, but earnings momentum for India remained negative till mid-July. Earnings, though, have started witnessing small upgrades over the past couple of months, though still largely led by export sectors. Contribution from the domestic economy is yet to be reflected in the earnings.
But history says that this is nothing to be worried about as earnings per share (EPS) upgrades historically have picked up over the next 2-4 months driven by cyclicals. These sectors could see a 20-50% EPS increase over 12 months driving 10-15% increase in India EPS.
In its report, Jefferies has analysed the past two economic recoveries to gauge how long the current rally can continue and how strong an earnings upgrade cycle can be. The analysis finds that, historically, Phase I of an economic recovery -driven market rally has been re-rating led and lasts for 7-8 months with markets rising by around 100%. By that measure, the current rally in the Indian markets has been only moderate in terms of performance, and the trend could continue for a couple of more months.
As per the findings, analysts historically have underestimated the impact of an economic recovery in earnings estimates, both in terms of timing and magnitude. In both 2003 and 2009, earnings upgrade cycle started 4-6 months after the start of the economic recovery and the peak of the upgrade cycle occurred 5-11 months after an economic recovery. The upgrade cycle is usually led largely by cyclical sectors like materials, industrials, utilities and discretionary.
Actual EPS growth for the first two years has been much stronger at around 20% as against estimates of 10% at the start of the recovery.
What is different this time around is that analyst upgrades are largely led by exports and defensive sectors unlike in the past, when it has been cyclical-led. Also, the financials sector is seeing upgrades in the current recovery indicating sharper gains in EPS going forward. If history is any indicator, says Jefferies, the earnings momentum could see a sharp rally over the next quarter led by Industrials and other domestic cyclicals.
Jefferies expects re-rating driven rally to give way to an EPS upgrade driven rally over the next few months, as seen in the past. Clearly, history has a habit of repeating itself.
