At its current level, the Sensex is now at around 15.3 times one-year estimated earnings, which suggests that there is still quite a bit of scope for a further decline
The S&P BSE Sensex, India’s benchmark equity index, fell 2.07% to 25,651.84 points on Tuesday, showing up the weakness in the market and once again raising the question of how low it can go.
In an environment fraught with global risks, the Sensex falls harder when valuations are higher, according to a report by Bank of America Merrill Lynch.
In the year following the European debt crisis in December 2010, when euro zone countries were unable to refinance government debt, the Sensex plunged 25% because market valuations were expensive (14% premium above the Sensex average price-to-earnings multiple) at around 16.6 times one-year estimated earnings.
Between March and May 2012, the Sensex fell around 6.8% over concerns of Grexit (Greece leaving the euro zone) because Sensex valuations were relatively cheap at 13.5 times one-year estimated earnings (below the average of 14.5 times).
Similarly, the Sensex dropped around 5.8% between May and August 2013 after the US Federal Reserve first hinted at a rate increase. Again the market valuations were below the 10-year average—at around 14.4 times.
The scenario has been slightly different this year. The Sensex has corrected only marginally by 3.8% in June after fears of the second Grexit, and 9.4% in August and September following the yuan’s devaluation by China. What is interesting to note is that the Sensex has not fallen by much even though valuations are high—at 16.9 and 16.6 times one-year estimated earnings.
At its current level, the Sensex is now at around 15.3 times one-year estimated earnings, which suggests that there is still quite a bit of scope for a further decline. Valuations came down much more during such corrections in earlier years (see chart).
Market analysts are citing downside risks, given global uncertainties—the Fed rate hike and China slowdown. “If China is going to continue to brush its problems under the carpet, it is going to haunt their economy and affect flows into emerging markets, including India," says U.R. Bhat, managing director at Dalton Capital Advisors (India) Pvt. Ltd, a unit of UK-based Dalton Strategic Partnership LLP that has over $2 billion of assets.
Foreign institutional flows have been under pressure because valuations are high. Foreign institutional flows into equities since the beginning of 2015 are at around $4 billion, the lowest since 2011.
“We continue to highlight that equities typically struggle if foreign portfolio inflows dry up at rich valuations," Bank of America Merrill Lynch said in an 18 September note.
The Sensex valuations are expensive as the Street is factoring in high double-digit earnings growth next year. “If we view current market valuation in light of 3-4% earnings growth so far, it is slightly expensive," says Bhat.
There may be more pain ahead as several brokerage firms are expecting the current trend of earnings downgrades to continue.
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