Sensex: What’s next?

December 29th, 2011

The anxiety to know where the markets are heading is only increasing while uncertainties abound. While there are many observations and possibilities, the most important question that comes to my mind: what’s in the price? Are Indian stock prices reflecting the worries that we are facing today with regard to what is going on or could possibly go wrong in the global economy, especially given the European crisis and the slowdown in Chinese economy? Most economists say the current global economic environment is extremely uncertain. And if the ongoing crisis manifests completely, the result could be devastating to say the least.

Here is what Marc Faber said when I asked him about his readings of the global economic crisis back in September, “We never really had a recovery in the western world. The stock markets went up because of the money printing and support in 2009. My view is that they can probably muddle through for another two-three years by piling up the fiscal deficit or printing more money. I do not know when it will happen - in 2012 or in 2018 - but the next crisis will be worse than the one in 2008.” Couple this view with that of domestic economists, who believe the homegrown economic issues are yet to play out, and the outlook isn’t bright.

Earnings downgrade cycle
So far from the peak in the month of January 2011, the Sensex has corrected by about 23 per cent. A large part of this has come from the Sensex earnings downgrades of about 10 per cent so far since January this year to currently at about Rs 1,130 per share. The second part comes from the P/E multiple de-rating, which typically happens when investors are expecting less growth and return on equity is expected to be relatively lower. At its peak in January 2011, the Sensex was trading at 16.5 times its one-year forward earnings, which has now dropped to 14 times. Effectively, the P/E de-rating has eroded another 15 per cent from the Sensex value followed by earnings downgrades.

What if in FY13 the Sensex EPS does not grow at all? Is that a possibility? Let us go back to history. Between FY98 and FY2000, for almost three years, the Sensex EPS remained flat at about Rs 280 levels. Again, very recently, beween FY08 and FY10, the Sensex EPS did not grow much. Let me tell you another interesting story. Last time, when the crisis hit in early 2009, analysts were expecting the Sensex EPS at Rs 1,240 for FY10. However, it actually tuned out to be 33 per cent lower at Rs 834 per share, which is huge and one can think of the difference that could occur between perception and reality when things go wrong. In that context, so far we have only seen 11-12 per cent downgrades in FY13 Sensex earnings.

There aren’t enough signs that we may see a situation like in 2008 and after, but there are enough headwinds in both the global and the domestic economy. The GDP growth has already been lowered and earnings are expected to suffer in the coming months partly as interest rates stay high. Even if we project a scenario of flat growth in FY13, the Sensex EPS could be around Rs 1150 per share.

Worst case
Now with flat growth in EPS what is the worst case for Sensex? If we take the reference of the 2008-09 global financial crisis, which was a classic case where both the global and domestic issues played large roles, the Sensex went down to almost 10 times its one-year forward earnings.

If we apply the same logic the Sensex value works out to nearly 11,300 points (forward Sensex EPS of Rs 1,130*10) or about 30 per cent lower from the current levels. But can the market trade at a P/E multiple of 10? Stock prices do not move only on fundamentals, but also because of sentiment and liquidity, which as we saw in 2008-09 forced markets to trade at lower valuations.

Recently there was a note published by Christopher Wood of CLSA where he said: “At this point, with the RBI hamstrung by stubbornly strong non-food core inflation, a violent sell-off down to the 11,000-12,000 levels on the Sensex, combined with a further depreciation in the rupee to the Rs 60/US$ level, now appears quite possible; most particularly in the context of any potential euroquake.”

Here the last line about the “potential euroquake” is very important, which is precisely what could impact the liquidity and the sentiment. It was not the fundamentals of the Indian economy that led to such huge sell-off in 2009, it was more to do with the sentiment due to the failure of the US banks and Lehman Brothers filing for bankruptcy in September 2008.

Here, the one cautionary statement is that this is an outcome, which is based on many assumptions. After all there is no harm in knowing the risk, whether it will materialise or not is a different issue. It isn’t as if there is no hope for long-term investors. In fact, the best time to invest in equities is when there is lot of pessimism in the market. Which is precisely what Warren Buffett says, “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

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