Markets in expensive territory, says BofA-ML

Sensex is at 28,893, just 107 points shy of the year-end target of 29,000 set by the brokerage

The ongoing rally has once again sent Indian markets into expensive territory and there could be a near-term pullback or time correction, says brokerage Bank of America-Merrill Lynch (BofA-ML). Time correction is a long period during which stocks return little to nothing, thus representing a kind of correction.  

The benchmark Sensex has climbed 8.5 per cent so far this year and has jumped 12 per cent since demonetisation lows in late December.

“In India, while we expect longer-term business cycle to improve in two to three years, we see near-term returns capped from here on due to a possible near-term reversal of global wave; market’s under-appreciation of residual impact of demonetisation; rich valuations and continued risks of earnings downgrade,” says Sanjay Mookim, India equity strategist, BofA-ML, which has set a target of 29,000 for the Sensex.

The 30-share bluechip index on Thursday closed at 28,893, just 107 points shy of the target. 

In terms of valuations, the Sensex trades at 17 times its estimated 12-month forward earnings. 

Mookim says the multiples are above long-term averages and at a level where historically the markets have struggled to deliver positive return over the subsequent 12 months. The brokerage says the markets may not have recognised the impact of demonetisation but it will be felt on earnings, particularly by companies in the discretionary sector.

“When companies speak of normalisation, they mostly refer to a restoration of volumes. Equities are, however, pricing in a restoration of growth. This difference is important, and still needs to be tested,” says Mookim, highlighting that the demonetisation may continue pose risk to the market.

Downgrade to consensus earnings estimates is another key risk for the market, the brokerage says. It expects five-seven per cent downgrade to consensus earnings estimates for Sensex companies. Meanwhile, it expects Sensex earnings to grow 12 per cent in FY18 and 14 per cent in FY19.

Additionally, rollout of goods and services tax (GST) in September quarter could create further earnings uncertainty, adding pressure on the markets, says BofA-ML.

Besides, the markets could come under pressure due to high primary market equity issuances, it says.

“We expect primary issuances to increase substantially in 2017 on the back of strong government disinvestment pipeline, and high valuations attracting new issuers (such as real estate investment trusts and infrastructure investment trusts),” says Mookim.

“This increase in issuances can increasingly absorb domestic flows and cap market returns,” he adds.

BofA-ML is overweight on financials, staples, and cement. It is underweight on information technology and discretionary segments.