Four months have gone by since the Sensex hit its all-time high and, despite the rally we’ve had in the past month, the mood in the market continues to be dour.
Some of the direst predictions have certainly not come true—as a matter of fact, March quarter earnings have proved to be remarkably resilient. A Citigroup research note points out that analysts have been surprised at the strength of earnings. With the results declared so far covering 70% of the Sensex stocks, earnings are up 17.6%, well above the earnings growth for the previous two quarters. The market had been expecting earnings to be buffeted by several headwinds: high input costs, losses on derivative transactions, a slowdown in demand and higher interest costs. While all these have had an impact, comapnies seem to have found the strength to withstand the storm and it’s heartening that the improvement has come about at the operating level.
Does it mean this is a common correction, much as the ones we had during May 2004 or May 2006? During both those market falls, it took five to six months for the Sensex to establish a new peak. For instance, the market high before the May 2004 meltdown was at 5,979 points in April and, after the crash in May, it wasn’t until November that the market reached a new peak. From the peak to the trough, the fall was 29%.
During the market correction of 2006, the Sensex reached a peak of 12,671 in May before falling 30.5% to 8,799 in June. However, the market had recovered all its lost ground by October, with the Sensex rising to 13,075 in that month.
How does the current fall compare? In 2008, we’re four months into the downturn, falling from a high of 21,206 in January to a low of 14,677 in March, a drop of 30.8%. But there are substantial differences compared with the corrections mentioned earlier. The biggest of them is obviously that there was no credit crisis in the developed markets either in 2004 or in 2006—then the scares were essentially that interest rates in the US would be raised and money would flow out of emerging markets.
Also, at home, the Reserve Bank of India was not in a tightening mode and the economy was not slowing. Moreover, inflation had not started hurting company bottom lines. And lastly, politics had not become so important and the elections were not so near.
How are these concerns being tackled? First, as Morgan Stanley pointed out in a note in early April, the bounce in earnings has led to a rise in the equity premium to more normal levels. The note said: “The near-30% correction in equities since January 2008 has been accompanied by a very small downward revision in earnings. Thus, the opposite of what happened between 2003 and 2007 has occurred over the past three months, i.e., the equity risk premium implied by share prices has risen... We think that this rise in risk premium has been led by risk aversion globally and the compressing growth and higher inflation outlook at home.” Since then, however, the Sensex has gone up almost 1,000 points, which means that while Morgan Stanley was right about it being a buying opportunity then, the argument has also lost quite a bit of its force now.
The surprising buoyancy in the March quarter earnings does, however, protect the downside. As the Citigroup note put it, although the earnings trajectory is still expected to moderate, the pace of that moderation may ease. In fact, since the downward risk to earnings is already factored into stock prices, the “downside risk to earnings itself could probably see some easing.” Brokers say there’s no panic in the markets now, although there’s no great enthusiasm either. What’s more, that conclusion appears to be true of the global markets as well, with the panic in the credit markets having abated since March.
The problem is that there’s still a lot of scepticism about the earnings outlook in future. At the global level, the consensus increasingly seems to be that while the worse of the credit crisis may be behind us, the focus will increasingly shift to the weakness in the US economy.
China too is in tightening mode, but growth will still be strong and inflationary pressures are also likely to remain high. Under these circumstances, if the European Central Bank may not want to reduce interest rates, the US dollar may continue to slide. And if that happens, commodity prices may remain high. As for crude oil, the price action of the past few weeks suggests that the link between the US dollar and crude oil has been broken. And news from insurer American International Group Inc. on Friday confirms that it will be a long time before the credit markets recover fully.
Back home, earnings are likely to continue to remain under pressure, not least because of the government’s heavy-handed efforts to rein in prices at the cost of the corporate sector. That’s why the upside too is limited: Citigroup has a fair value of 18,500 for the Sensex for April 2009, which includes 3,500 points on account of embedded value. As the report says, “This translates into a FY09E P-E multiple of 17.4 and 18.5x ex-oil etc. This would be a 9% premium to its 18-year average, as also a 23% discount to its recent peaks. It would remain at a 17% premium to regional peers.” That’s not much of an upside—as Friday’s markets seem to demonstrate, the April rally may have been a dead bull bounce.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at firstname.lastname@example.org.