Other markets aren’t in the same boat, though. The Dow Industrials and the FTSE index are up around 9% since end-September. Emerging markets haven’t been doing very well of late and the Hang Seng has had just a marginal gain since September, while South Korea’s Kospi index is below where it was on 30 September. At the same time, though, Jakarta is up almost 8%, the Shanghai Composite Index almost 10% and Brazil’s Bovespa 13% since end-September. So it wouldn’t be right to say that all emerging markets have done as badly as the Sensex.

Graphic: Naveen Kumar Saini / Mint

What’s the reason for the Sensex’s tepid performance? It can’t be growth, because both the macro indicators and earnings have been improving rapidly. Simply put, valuations shot up too rapidly for the Indian market. A Morgan Stanley report in late September, quoted in this column around that time, had warned that “the market is pricing in almost all the growth recovery that we are forecasting in the coming six months". The trailing price-earnings multiple for the Sensex had moved up from a terribly undervalued 12.6 in March 2009 to a high 21.2 by September. Currently, it’s at 20.8.

In their recent India Strategy chartbook, Morgan Stanley analysts write: “History suggests (and we go back to 1997, 2000, and 2004) that the market multiple tends to decline when short rates inflect in the upward direction. While in 1997 and 2000, the rate rise happened in a slowing growth environment, causing significant damage to market multiples, the 2004 rate change took place in an accelerating growth environment, and the fall in market P-E proved temporary. We believe that the current environment resembles 2004, with a rise in short rates likely to pre-empt inflation pressures in an accelerating growth environment."

The chart shows how the current rally compares with the one in 2003 and 2004. Between 1 April 2003 and 9 January 2004, the Sensex rose by 106%. That’s comparable to the 103% rise between 1 March 2009 and the peak of 17,790 points on 6 January. But the trailing P-E is higher this time. What may be more unsettling, though, is the fact that, in 2004, the Sensex wasn’t able to reach its January high before December that year.

But then, the trend line of the rally in 2004 was different—stocks didn’t go up sharply and then remain static for several months. This time, the fact that the Sensex has done nothing for the last six months could help the bulls. Morgan Stanley, which made the right call six months back, is bullish and says that their “probability-weighted outcome for the BSE Sensex is 19,400 for December 2010."

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