Has the slump in stocks gone deep enough? That’s the question everybody wants answered and it’s not surprising that analysts are turning to past bear markets to figure out if we’ve hit the bottom. One way to do that is to consider market valuations. A recent equity strategy report by Citigroup is a picture of gloom on this score.
The report, Trend will be support but trend is a fickle friend, by Markus Rosgen, Elaine Chu and Chris W. Leung, compares the price-to-book value of the current Asian markets (as on 25 March) with that during previous downturns and finds that “if this slowdown is just like those of 1990 or 2001, markets have a lot more downside. Even if it is only half as bad, markets could still fall by a further 20%.”
The price-to-book value of Asian markets, excluding Japan, currently stands at 2.3 compared with the 2000-01 low of 1.2. For the Indian market, current valuations are even higher, with price-to-book value at 4.9 compared with the 2000-01 low of 1.6. Based on these calculations, Citi believes that the probability of a negative 12-month return is 77% for the Indian market and 100% for the Chinese and Indonesian markets. The analysts point out that even if they use a composite valuation indicator, comprising one-third weights in price-to-earnings, price-to-book value and dividend yield, “valuations became rich late last year and have as yet not moved back to average, let alone cheap, territory.”
Moreover, corporate earnings are also usually revised downwards during the downward phase of the economic cycle. The report estimates that while Asia ex-Japan earnings-per-share growth is currently seen to be 8.4% for 2008, after adjusting for the median error rate, it could fall to a measly 2.7%. For India, against the current expectation of a 22.2% rise in earnings in fiscal 2008, after adjusting for a median error rate of 8%, earnings growth could be as low as 14.2%.
After pointing out that it doesn’t make sense to use current earnings estimates, the report computes average mid-cycle earnings and concludes that, “at a 32.2% discount to mid-cycle earnings, the market is already pricing in a fair amount of downside to earnings forecasts for Korea. This is not the case with markets such as India or Indonesia.”
It also points out that amid the gloom and doom in the Asian markets, the technology sector is trading at a 16.9% discount to mid-cycle earnings, banks at a 10.9% discount and telecoms at a 0.8% discount.
The analysts write, “This is not a state of affairs that we expect to continue for much longer. We are overweight in telecoms and banks and have a small underweight in tech. All the signs are that consensus is beginning to move in this direction, too.”
The basic assumption behind the analysis is that markets revert to the mean. But the relatively high valuations in the Indian market have been justified on the assumption that there has been a structural change in the Indian economy on the back of low interest rates and high savings and investments rates. And even though growth rates are being revised downward, so far nobody is questioning that theory.
But if the structural change theory doesn’t hold, how low can we go? The Sensex’s historical price-earnings multiple is around 20 at present—in 2002, during the last bear market, it had fallen to as low as 12.7.
Duty cuts have the desired effect on agri-commodities
The government’s decision to cut import duties on edible oils has resulted in a sharp decrease in their futures prices on the National Commodity and Derivatives Exchange. The exchange’s Futexagri index fell by 2.31% and its counterpart, based on spot prices of the underlying commodities, declined by 0.88%. But these indices are made up of a large variety of commodities, most of which haven’t been affected by the government’s latest measures.
The spot price of refined soya oil in Indore fell by 6.5%, data disseminated by the exchange shows.
The exchange publishes spot price data based on polls done in these markets.
Prices of refined soya oil have fallen more than 20% from their highs in early March, thanks to the two sharp cuts in import duty announced in a span of less than two weeks.
The fact that both futures and spot prices of edible oil have fallen leaves little doubt that the correction is genuine and that the government’s measures will indeed check price inflation in these commodities. The reason for the fall is simple: Around 50% of the country’s edible oil requirement is imported, and the sharp duty cuts will lead to a significant decline in landed cost.
But even at current levels, prices of edible oils such as refined soya oil are about 20% higher than the year-ago levels, and as long as global food prices remain high, checking inflation on this count would continue to be challenging.
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