50% chance that the markets will stage a recovery: BofA-ML report

BofA-ML's analysis of past 50 such market falls in the last 35 years shows mixed results

Global equity markets have lost considerable ground in the last two sessions on the back of growth concerns in China. The Indian benchmarks, the S&P BSE Sensex and the CNX Nifty witnessed their biggest single-day fall in over six years and wiped out over Rs 7-lakh crore in investor wealth.

Also Read: Shanghai Composite slumps 7% as panic selling intensifies

Despite the sharp fall seen in the last two sessions, Indranil Sen Gupta, India economist with Bank of America-Merrill Lynch (BofA-ML) expects the markets to remain in a range till given the global uncertainty and weak earnings.

"Equities had its largest one-day fall in absolute terms with the BSE Sensex falling 5.9%. We think this was largely on concerns of global risk-off due to worries related to China. However, in percentage terms, this is merely the 27th largest fall (since 1990 when India liberalised)," he says in a recent co-authored report with Abhishek Gupta and Anand Kumar.

So will markets rebound and do well in near term after such a steep fall? BofA-ML's analysis of past 50 such instances in the last 35 years shows mixed results.

"While average one-month and three- months returns are positive at 2.1% and 4.1% respectively, the probability of positive instances are no better than a toss of a coin," the report says.

BofA-ML also expects capital flows stalling till expected September 17 US Federal Reserve hike is priced in.

"In our view, this is not so much a macro worry - thanks to falling oil prices - as a market risk. The BSE Sensex one-year forward PE (adjusted for earnings downgrades) has slipped to 16.1x from 17.5x but remains above the long-term average of 14.5x," it says.

Valuations

Valuations, according to the research house, have moderated but are still above average. Based on current earnings forecasts, the BSE Sensex is now trading at 15.3x 12-month estimated forward earnings, BofA-ML says, which is largely in-line with historical average of 14.5x.

However, adjusting for earnings downgrades to consensus Sensex EPS estimates, index is trading at around 16.1x 12-month estimated forward earnings, which is still around 12% premium to long term averages, it says.

The report also highlights that equities typically struggle if FPI (foreign portfolio investor) inflows dry up at rich valuations and cites European crisis of 2011 when the Sensex was trading at a 14.3% premium in terms of one-year forward PE and the markets corrected by 25% when FII inflows reversed.

"At the same time, in the other two episodes of Grexit I and the Fed taper tantrum, the Sensex was reasonably valued to start with. Hence, the equity correction was limited to 6-7% in response to a knee-jerk reaction of FII outflows that were relatively short-lived," BofA-ML says.