Mumbai: Fears of anti-inflationary measures hurting economic growth, negative sentiment over corruption and corruption cases in key sectors such as telecom, real estate and banks have begun hurting the valuation of Indian stocks.

Worried investors have started derating the price-earnings (P-E) multiple of India’s benchmark index, the Sensex, signalling the current correction could be deeper and the gauge may not bounce back to its recent highs too soon.

The Sensex has lost 20.2% since 5 November, when it closed at a record 21,004.96 points. In 2011 so far, it has lost 1,650 points, or 8%. Foreign institutional investors withdrew a net $407 million (Rs 1,844 crore) in January after pumping in a record $29 billion in 2010.

India has been the worst performer among major global indices in January. The Dow Jones Industrial Average, Japan’s Nikkei 225 and Brazil’s Bovespa have all clocked positive returns.

The value of an index is a function of its earnings and the valuation investors are willing to pay, also called P-E. The consensus earnings per share for the Sensex has hovered around 1,200 for fiscal 2011.

At 20,509 points at the beginning of the year, the index was commanding a valuation of 17-18 times forward earnings. But this P-E multiple has been derated to around 15 times, according to at least half a dozen brokers and asset managers. This means the fair value of the index is around 18,000-18,500 points, analysts said.

“In a gradual manner, the market is derating on concerns that growth may slow down next year. If indeed growth slows down, then corporate earnings will also slow, and there is no way the P-E multiples can go up," said N. Sethuram, chief investment officer, Daiwa Asset Management India Pvt. Ltd, which has 135 crore of assets under management.

Investors say the derating is largely due to fears that India’s much-publicized 9% growth rate cannot be sustained without stoking inflation.

“Investors were giving a valuation of 17 times forward earnings taking Sensex to 20,500 levels. This valuation was based on the GDP (gross domestic product) growing at 9%," said Dinesh Thakkar, chairman and managing director of Angel Broking Ltd. “But with inflation flaring up, these growth levels are no longer sustainable. So, we may have to temper down expectations and valuations need to be moderated."

The macroeconomic scenario—with a high fiscal deficit, current account deficit and inflation—remained unchanged for most of last year.

The wholesale price-based inflation (WPI) has accelerated to 8.43% in December from 7.48% in November, and the October inflation figure has been revised upwards from 8.6% to 9.1%.

Ashutosh Datar, economist at India Infoline, said the upward revision in October’s WPI was disconcerting.

“Given the recent rise in food inflation, we expect inflation to remain almost two percentage points higher than the Reserve Bank’s projection of 5.5% by March 2011," he said. “Consequently, we expect the central bank to resume policy tightening later this month with a 25 basis points hike and a cumulative hike of 100 basis points in 2011." One basis point is one hundredth of a percentage point.

Widespread apprehension that government steps would be harsher this time is hurting investor sentiment.

“Though these (indicators) were at similar or even worse levels over the past year, now there is a change in perception that none of the measures taken by the Reserve Bank is working. Ultimately, the only way to rein in inflation is by taking measures that may hurt growth," Sethuram said.

“A rate increase is almost inevitable," said Kislay Kanth, head of research, MAPE Securities Ltd. “To cool down the economy and counter the surge in inflation rates since they started running away from November 2009, the Reserve Bank may have to further increase the rates, which may reduce some of the liquidity from the banking system."

A further reduction in liquidity is the last thing the stock markets need.

“Price-earnings is a factor of money supply," said Manish Sonthalia, vice-president, Motilal Oswal Financial Services Ltd. “Liquidity has been very tight and global investors have turned to other markets which are doing better. Heavy inflows that we were seeing some weeks ago are not there."

Investors say the market is factoring all these into account and investors are now ready to value India at 15 times future earnings.

“This should take us to a level of 18,500. Until we reach this level, we will continue to see some volatility. The index would consolidate around this level before earnings growth takes us forward," Thakkar said.

In addition to high inflation and fiscal deficit, corruption inquiries in key sectors are also affecting investor sentiment, said Anish Jhaveri, CEO, Antique Capital Ltd.

“The India story is a slightly longer-term story," he said. “If the UPA (United Progressive Alliance) government is able to make adequate steps to tame inflation and take care of corruption by June, the Sensex could get back its old valuation."

According to Sethuram, much of this derating has already happened, with the benchmark Sensex losing over 2,000 points in the first two weeks of the year. “Ideally, we have now come down to 15-16 times forward earnings, which is a more comfortable level," he said.

Sonthalia also says at 15 times, the index is hovering slightly above its long-term average valuation of 14 times forward earnings. “If inflation is brought under control by March, P-E levels of 17-18 times will be back." he added.

Vikrant Gugnani, chief executive officer, Reliance Securities Ltd, said the dependence of the market on interest rate-sensitive sectors has come down considerably.

“Domestic demand is so strong that the pricing power of domestic businesses will continue to remain high," Gugnani said. “This will help markets regain their earlier levels sooner than later."

Credit Suisse expects Asian equities to offer returns of 20% in 2011 and the Sensex to underperform with a rise of 8.5% to a level of 21,650 in December 2011.

Citigroup analysts project a Sensex target of 22,000 for December 2011. Both these projections were made in end-December.

Kotak Securities put a six-month Sensex target of 21,000 points in its 17 November strategy note, saying valuations are already factoring in earnings for the fiscal year ending March.