The maximum number of questions I face these days are related to the valuations of the market and the fact that most people are of the opinion that valuations are stretched and thus do not leave too much room for appreciation.
My answer to this is that at the first stage of a bull impulse when most analysts and companies have not recovered from the blow that they have taken from the bear run most of them tend to be conservative on their outlook for growth and at this stage both economic recovery and earnings growth tend to be understated. Looking at valuations today the market P/E is in the region of 20X historic earnings and around 18.5-19X current year expected earnings. The consensus earnings growth estimate for next year stands at around 20% i.e. the markets on one year forward expected earnings are trading at valuations of 15 times 2011E earnings. This is reasonable in the context of the current interest rate environment and growth prospects.
My views on the same are that the economy is just starting to recover and it will gain significant momentum over the next few months and most analysts are underestimating the strength of the economic recovery. Industrial production growth which has averaged 10% over the past two months is likely to average at around 12% for the next six months. As the figures improve the estimates of earnings growth for the next year and somewhat for the current year will also improve. I believe that there is a great possibility that earnings growth for the next financial year will be more near 30% than 20%. In case that possibility fructifies the P/E ratio comes down to around 13.5X one year forward earnings which makes the market actually attractive relative to future growth prospects.
In my view the earnings growth will not only pick up but also sustain at levels of 20-30% for the next few years.
The other key concern is what happens when RBI starts to tighten monetary policy. It is important to then understand what will prompt RBI to tighten, it will be an estimation that growth is stabilizing and improving and that inflation is picking up due to demand pressures. If that is the logic for increasing policy rates then it is actually a bullish signal for the markets rather than a bearish signal. As such i would not be too bothered about monetary tightening at this stage. In any case given the state of liquidity in the system and also the fact that Bank Credit growth on a Year on Year basis is just around 10% as against a deposit growth of 19%, it is highly unlikely that interest rates for consumers and corporates are going to move up in a hurry.
Moreover if one goes and looks at valuations of the markets at the end of 2003 valuations would have looked stretched mainly because growth estimates for the future were understated. In any case in most bull markets the valuations move up and sustain at elevated levels for a prolonged period of time and there is no reason to believe that the same will not happen this time also.
India’s V shaped recovery
Now it is clear that the Indian economy is going to see a V shaped recovery and the main contributor to the same will be the inherent strength of the Indian consumer as well as a sharp pick up in investment demand. The income of rural households also is strong mainly due to high foodgrain and crop prices.
I believe that the biggest strength of the Indian economy lies on the strength of the Financial system in which Indian banks today sit on historically high capital adequacy. This has been possible due to strong controls on NPA’s, cost control and strong growth in profits. The average capital adequacy of large Indian banks stand at over 15%. This will enable the banks to expand their balance sheets aggressively as the recovery sets in. This is in total contrast to Western economies where large banks are being forced to cut their balance sheets by upto 50% as part of thier bailout packages.
Indian corporates have cut down costs aggressively and raised equity worth over USD 12 billion over the last six months. This will help them expand their business strongly as the recovery sets in. Employment has also started to pick up across services and manufacturing sectors, a total contrast to rising unemployment in the West.
Overall sectors like Financials, Infrastructure and Oil & Gas stocks should do well and lead the rally. Pharma and Technology should continue to do well. Over the next couple of months the markets look like rallying by around 10% from the current levels.
Subsequently I believe next year could be difficult for the markets as they absorb the gains of the current year. Fundementally I believe that next year might be a more subdued 15-20% kind of growth year. However the technical picture looks much more bullish, indicating a move upto around 21000 for the Sensex and 7000 for the NIFTY before any big correction fructifies. I would frankly stick to my fundemental view at this stage.
“In a bull market the game is to buy and hold until you believe that the bull market is near its end”