We are now in the second year of the recovery. The Sensex started moving up from March 2009, which makes September the 18th month of the recovery. Yet despite the recent surge, the mood in the markets is one of caution. The second year of a recovery is always a bit jittery. Memories of the recent downturn linger and investors worry about the market going up too far too fast. In 2004, the second year of the last recovery, the Sensex moved up just 12.4%. The first year of the recovery is one of expansion in price-earnings multiples, while the second year has to depend on earnings increases. Naturally, it makes for lower returns.
But the trailing P-E multiple for the Sensex is already at around 23. In contrast, 18 months into the last recovery, in November 2004, the Sensex trailing P-E was around 18. It was only in December 2006 that the Sensex’ trailing P-E went up to 22.5. No wonder then that most fund managers surveyed by Bank of America-Merrill Lynch this month believe we are in the mid to late cycle stage despite being just about a year and a half into the recovery.
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There isn’t much room for comfort even if we rely on forward P-Es. At consensus estimates of Sensex earnings per share of Rs 1,046 for FY11, the market is valued at around 18.6 times, which is by no means cheap. Nor are analysts in any hurry about revising earnings estimates upwards.
Nevertheless, as the chart shows, the trailing P-E multiple of Sensex is not much higher than where it was in January this year. Indeed, the trailing P-E was as high as 22.7 in mid-January. Thereafter, it has been well below that level and it is only in this month that we’ve crossed it. Viewed from this perspective, therefore, all the market has done so far is make up lost ground.
Graphic: Yogesh Kumar/Mint
The other metric where this recovery differs from the earlier one is with regard to interest rates. In September 2004, the yield to maturity on the 10-year government bond was 6.2% and it wasn’t before mid-2007 that yields started going above 8% in a sustained manner. This time around, the yield on the 10-year government bond is already hovering around 8%. That’s despite the policy rate being lower than where it used to be in September 2004, when the repo rate (then called the reverse repo rate) was 6%. It’s 5.75% now. It’s very likely that the government’s huge borrowing programme—it recently said the fiscal deficit will remain high in spite of the 3G spectrum auction bonanza—is buoying interest rates.
Bank deposit rates too are higher than where they used to be in year 2 of the last cycle. That’s because liquidity with banks is much tighter. In September 2004, the credit-deposit ratio of scheduled commercial banks was around 57%—currently, it’s 71.7%. But one interesting difference between the last recovery and the current one is that bank credit growth is lower. By September 2004, for instance, bank credit was growing by 24% year-on-year (y-o-y). Currently, the y-o-y rate of growth is still below 20%. That’s because companies have raised far more money from the capital markets.
The main difference between the two recoveries, however, lies not in the real economy but in the amount of liquidity finding its way to Indian shores. Data from the Securities and Exchange Board of India show that net foreign institutional investor (FII) investment in 2009 and in 2010 so far has been far higher than that seen in 2003 and 2004. This is what has pushed up valuations so far so fast.
There are several reasons for the inflow of funds. One of them is based on economic fundamentals. International Monetary Fund (IMF) data show that the advanced economies increased their gross domestic product (GDP) by 3.2% in 2004, while developing Asian countries’ GDP increased by 8.6%. The IMF forecast for 2010, however, is GDP growth of 2.6% for the advanced economies and 9.2% for developing Asia. The reasons for putting your money in Asia are, therefore, stronger today than in 2004, apart from the fact that the India story is now much more widely known. The second reason is the very low rate of interest in the developed countries. For example, the yield on the US 10-year treasury note is around 2.7% at present—it was over 4% in 2004. That acts as an impetus to funds seeking higher yields on the one hand and to place bets using borrowed money on the other. And finally, the carnage in Indian mutual funds, which led to a wave of selling in the last few months, appears to have abated. Selling by mutual funds has been lower this month, which is one reason why the market has gone up so much recently.
As long as these conditions persist, flows to Indian equities will continue to be very strong, although they will be punctuated by bouts of profit-taking in view of the very uncertain external environment.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at firstname.lastname@example.org