India's equity risk premium high: Morgan

The recent fall in share prices by over 30 per cent "" from the Sensex level of 12,612 on May 10 to 8,929 on June 14 "" is defensible, despite the lack of any apparent change in fundamentals.

According to a recent research report of J M Morgan Stanley, there are three basic reasons behind the fall in the market. First, there is contraction in global risk appetite.

Second, the latter part of the bull market was driven less by fundamentals and more by the price of risk. And, finally, the price of risk of stocks has risen and thus expected returns are higher.

The JM Morgan Stanley research report says that India's equity risk premium (ERP) should be around 6 per cent, consistent with the long-term volatility trends.

Using this ERP and assuming a long-term nominal gross domestic product (GDP) growth forecast of 11 per cent and a target market cap to GDP ratio 80 per cent, the market is about 34 per cent above fair value.

In other words, if the market falls 25 per cent from its current level, it will likely deliver a long term compounded annual return of 13.8 per cent (6 per cent ERP plus 7.8 per cent risk free rate).

If the valuation benchmark is raised "" target market cap to GDP ratio is taken at 100 per cent "" the market is trading 3 per cent above fair value.

The fair value of the BSE at various ERP shows that the Sensex could go down to 8,808 levels if ERP at 4 per cent with a target market cap of 80 per cent of India's GDP at the end of 10 years. The Sensex could be at 8,062 at 5 per cent ERP and at 7,379 at 6 per cent ERP.

If the ERP is indeed 6 per cent, it implies that market is about 34 per cent above fair value using 80 per cent as the target market cap to GDP, a nominal GDP growth of 11 per cent and the 10-year current bond yield of 7.8 per cent.

This is another way of saying that the market has to fall 25 per cent to deliver a 10-year compounded annual return of 13.8 per cent (6 per cent ERP plus 7.8 per cent 10-year bond yield).

As per the report, equity risk premium or the price of risk was the most important element to the bull market, evidenced by market cap to GDP model.

This model depends on long-term GDP growth forecasts and thus short-term fluctuations in share prices are attributed to changes in the perceived discount rate.