A double-whammy on earnings front

There is a tipping point in the economic cycle when bold policy measures are required to sustain momentum. By the third quarter of 2006-07, that point had surely been reached.

Manufacturing industries such as cement and automobiles were operating at over 95 per cent capacity. The credit-deposit ratio was well above the danger mark and credit was rising at over 30 per cent despite rate hikes. Power equipment suppliers had two fiscals worth of orders on their books.

The third quarter is when the finance ministry gets into Budget-making. Rather than gamble on bold reform measures or big tax cuts to sustain momentum and animal spirits, the FM delivered a do-nothing Budget.

The market reaction suggests traders and investors alike are disgusted with the neutral, safety-first approach. Short-term market moves often counter to fundamentals but this one seems based on sound judgment.

Opinion about the Budget ranges from mildly disapproving to violently negative. For example, the MAT on IT companies removes a potential haven.

The retrospective removal of Section 80 IA benefits for infrastructure players will hurt a growth industry. Service tax on commercial rentals will hit real-estate, retail, IT and ITeS companies.

Most analysts are downgrading their earnings estimates across the board. The earnings downgrades will not be very large. Growth in 2007-08 will be acceptable by normal standards but normal growth cannot justify current valuations in the face of rising rates.

The only driver since third quarter, 2005-06, has been sustained EPS (Earnings per share) growth.

In February 2007, the Nifty was trading at an average PE of 20 implying an earnings yield of about 5 per cent.

Short-term Treasury Bill (T-Bills) yields were near 8 per cent, implying that PEs of 13-plus were dangerous.

The correction has knocked the Nifty's average PE down to 18 but that is still way above the redline.

It's exceedingly unlikely that interest rates will drop. So, the valuation contradiction can be resolved in two ways. If the Nifty could deliver 2007-08 EPS growth of 25-30 per cent, that would justify PE 18.

Otherwise, a deep correction is required to slide closer to an average PE of 12-13. The latter is more likely given the Budget. So we're looking at a double-whammy of earnings downgrades coupled to valuation downgrades.

A look at the key players on the domestic bourses leads to an increase in pessimism. Thanks to the disclosure norms of the Securities Exchange Board of India (Sebi), we have a pretty good idea of short-range foreign institutional investor (FII) and mutual fund attitude.

It's possible to guess the domestic traders' attitude by a process of elimination.

Since January 2007, domestic funds have been bearish. They are collective sellers in 2007, raking in Rs 1,645 crore. Since the Budget, they've been marginally positive - buyers of Rs 214 crore by March 1.

The FIIs have been net buyers since January 2007, netting Rs 5,648 crore. Since the Budget however, they have sold just over Rs 2,500 crore "" more than 10 times as much as domestic mutuals have bought. Domestic operators and retail traders have not absorbed that selling, but that is not the real problem.

The FII sell-off could continue for a variety of reasons:

According to some calculations, anywhere up to 85 per cent of FII inflows in 2006 were through PNs. Much of that cash was Yen-converted. The Yen rate hike has made the carry trade dangerous and cut off an important source of cheap funding.

The Chinese meltdown and fraud has spooked investors across the globe

The budget will have a negative impact.

So where should you go with long-term investment horizons? A few sectors seem unaffected. Pharmaceuticals has perked up post-Budget. There is also renewed interest in gas distribution networks and in associated industries like pipe manufacturers.

Power equipment shares are also doing well. IT has taken a knee-jerk hit "" MAT isn't really going to knock spots off growth in this industry.

Hospitality stocks with NCR exposure could do well due to a combination of booming tourism/ business travel and tax holidays.

In the context of overall asset allocation however, it does make sense to ease off on equity. Somewhere between 10 and 20 per cent of your portfolio should go into inflation-proof instruments.

The conservative choices are fixed maturity plans and floater funds with short tenures. The brave man's choice would be long commodity futures.