 "What earnings downgrades means for Sensex")
Every time the market’s one year forward price/earnings multiple dips below its 10-year average, which now stands around 14x, the stock market pundits rise to say 'Buy'. But in the current context this advice could prove to be dangerous because the base case could be much worse than the present.
There are too many variables at work right now. For starter, the foreign institutional sell off is not yet over. Even though FII flows over the last three months have been negative, experts say FIIs still own nearly 45% of the free-float and 22% of the listed universe. Hence, they could sell more if things deteriorate further. Economic growth for the first quarter ended June 2013 has come way below expectations at 4.4%. Despite the sharp fall in the rupee, markets have not seen sharp fall unlike past experiences. This also means all the risks are still not factored in yet. On a year-to-date basis, India’s equity market has not been the worst performer despite the rupee’s fall and other structural issues.
In tough global conditions, Indian equities are known to trade at valuations of 10 times one-year forward price-to-earnings. The current situation is nowhere near that. A low PE also does not mean cheap markets, as the definition of “cheap” changes based on other factors, especially earnings.
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Given the optimism built around earnings growth both for FY14 and FY15, the P/E ratio is looking cheap but in reality it isn’t cheap, if one factors in the downgrades, current and potential. CY13 is turning out to be a dull year for Indian equities. The 8% decline in cumulative earnings for Sensex companies in Q1FY14 portrays a worrisome forecast for rest of the year after five-year CAGR of 9%, says one report by ICICIDirect.
With the rupee’s fall and oil prices rising, the stress is only expected increase on the economy.
In the first quarter of the fiscal itself, 55% of the government’s fiscal deficit target has been reached. Given that it is a pre-election year, spending cuts won’t happen this year like last. This means that fiscal stress will continue painting a dull picture for investors. All this also means that earnings downgrades are not stopping anytime soon as too much optimism has been built around them. Based on analyst estimates, the EPS of Sensex is expected to be Rs 1,305 in FY14 and Rs 1,540 in FY15. Bank of America Merrill Lynch expects the same to be downgraded to Rs 1,260 and Rs 1,400, respectively.
Dhananjay Sinha, strategist at Emkay Global, believes that the market is factoring in a double-digit earnings growth, which is too optimistic. Consequently, the benchmark index can go down further, given its lower earnings trajectory. In times of a global crisis, forward PE of the Sensex has fallen to 10x, however, given that the developed world is recovering, analysts expect the forward P/E to touch 11.5x in the worst case scenario.
Based on this, Bank of America Merrill Lynch believes in the worst case scenario, the Sensex could go down to 16,000 levels.