An upcycle in earnings, strong global liquidity and supportive valuations should help the market rise around 25 per cent in 2013. We expect Sensex earnings growth of 10 per cent and 19 per cent in FY2013 and FY2014, respectively, and hence, markets to rise largely on higher earnings. Of course, there are risks to this view from a major risk-off in the world, domestic policy hiatus, early elections and rising oil prices. Our framework suggests four fundamental ingredients to a bull market — a bullish steepening of the yield curve, expanding profit margins (to translate gross domestic product growth into profit growth – higher share prices need profit growth), attractive valuations (the story is not in the price) and liquidity. Ownership and sentiment are also important and, to that extent, trailing performance, as it completes the virtuous circle that drives bull markets in equities.
Currently, the valuations are attractive and ready for a new bull market. The yield curve is laying the groundwork and has stopped its bearish flattening. Sentiment also visited a historical low at end-2011 and has improved since then. Profit growth is entering a period of recovery but we do not believe a full-blown margin expansion cycle is on hand. Corporate fundamentals in 2012 have been relatively better in India than the rest of the world, which explains why India has received significant foreign institutional investor flows this year and might continue to do so in the coming months. The biggest impediment to a roaring bull market is the state of domestic liquidity.
Short-term interest rates move around with liquidity. However, the liquidity stock markets need varies with the level of share prices (i.e. valuations). Liquidity required to move stocks is higher when share prices or valuations are higher. Our model suggests the market needs a front-ended rate cut of circa 100 basis points to make progress if domestic liquidity is the sole criterion. The fundamental block to an improvement in domestic liquidity is the tight balance of payments, in turn linked to the high fiscal deficit. So, positive delta on this front will help.
In contrast, global liquidity indicates a very bullish outcome for Indian shares. Our indicator for global liquidity is measured using the difference between the trailing earnings yield and the US 10-year bond yield. This is currently at 4.7 per cent, consistent with very strong one-year forward returns from Indian equities. The actions by global central banks have taken away the tail risk associated with India’s large external deficit. This is a key area where investors need to keep an eye out for a disruption of the market’s ascent.
We sense a need to move portfolio strategy. The correlation of stocks with the Sensex is approaching lows, warranting wider sector positions. Cyclicals look ultra cheap vs defensives, supported by a likely trough in earnings growth. As earnings growth recovers, we expect the preferred investment style to shift from quality to ‘GARP’ (growth at a reasonable price). Small- and mid-caps look very attractive. Hence, our strategy is to prefer cyclical sectors. Our pecking order is financials, consumer discretionary, industrials, energy and materials. We focused on earnings per share growth and a positive delta in return on equity for stock selection, while avoiding high financial gearing and remaining sensitive to valuations.
The author is strategist & head of India equity research, Morgan Stanley