Is Sensex at 18x fairly valued? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Is Sensex at 18x fairly valued? 

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In this issue:
» What's driving FIIs to Indian debt markets?
» Should we redefine fiscal deficit target
» Is ECB brewing a disaster for European economy?
» Central banks are silent : Should we be worried?
» ...and more!

All economic indicators suggest that emerging markets, including India, are going through a rough patch. Then why is it that the Indian stock markets are setting record highs? Infact, for around nine days in a row, Indian stock markets had been rising until a correction today. One of the key factors driving the Indian stock markets is the hope that Indian economy will see better fortunes post elections. The investor optimism stems from hope that business friendly alliance will form a stable government which will speed up reforms and speed up economic growth.

At the ground level, nothing has changed to suggest a sustainable improvement in fundamentals of the Indian economy. It's true that certain macro economic indicators for India like exchange rate, current account deficit and inflation all are showing sign of easing. However, this improvement is more driven by the restrictions on imports, external variables or factors beyond control. Any recovery in other emerging markets or developed markets is likely to be followed by an outflow of hot money from Indian stock markets. And this is likely to add pressure on rupee, making things worse for Indian economy.

But going by the current valuations, Indian stock markets seem to be back in favour with the global invesors. As per an article in Business Standard, the Morgan Stanley Capital International (MSCI) India index suggests that India is the most expensive markets among the emerging markets and BRIC Nations, with a price to earnings ratio of 18 times. This compares to an average PE of 12 for emerging market economies, a premium of around 48%. Is this premium justified? Further, will it sustain? It is important to note here that current valuations for Sensex are only slightly above long term average.Hence, while the valuations might not look alarming now, we would rather be cautious as the economic recovery is far from sure footed , making current rally quite volatile.

An important question investors should consider here is: Will a new Government be able to bring in reforms quick enough to ensure economic recovery soon? We don't think so. What is crucial about policies is not just an announcement but timely implementation. And that's something that no party seems to have a good track record at. Whosoever gets elected next, will not just have the old mess to clear up but new economic challenges to deal with, for e.g., Food Security Bill. And these will just be the internal issues. External issues like Fed's policies and global macro economy are likely to make things more challenging.

Thus, even with the best possible election outcome, in a scenario of low demand and massive overcapacities, the likelihood of the growth revival in the near future is low. Especially in case of a coalition Government, it will be better not to keep expectations high. And in case the election outcome does not turnout as expected, we believe that markets might be in for a rude shock.

Hence, investors would do well not to get carried away with speculation driven rally and base their investment decisions on keeping every stock's fundamentals, valuations and risk factors in mind.

Do you think that Indian stock markets are fairly valued? Let us know in the Equitymaster Club or share your comments below.

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02:00  Chart of the day
After witnessing an outflow for three consecutive quarters, the Indian debt market saw an influx of FII money in the quarter ending March 2014. As can be seen in today's chart, more than Rs 350 bn made its way into Indian debt markets in the March quarter. High yield on Indian debt and improved macro-economic signs have led to a sudden influx of FII money. Foreign Institutional Investors (FIIs) are taking solace from improved current account deficit (CAD) situation and narrowing fiscal gap.

However, the primary reason for such huge inflows is increased carry trade profits resulting from rupee appreciation. Carry trade is a practice of borrowing in low yield currencies and investing in high yield currencies. Interest rates in global markets are in the region of 2-3% while the Indian government bond yields 8-9%. Hence, investors can borrow globally and invest in India thereby earning a healthy spread. This carry trade blossoms when the rupee appreciates as it further increases the dollar return to the global investor. This is what seems to be happening now. Expectations that the rupee will appreciate further has led to huge FII inflow in debt markets.

However, it may be noted that India is facing huge political uncertainty now with elections nearing. Also, CAD and fiscal gap were plugged due to artificial measures taken by the government like banning gold imports and milking PSUs respectively. Thus, the economic situation is not that bright. If it worsens, the FII money will flow out. And this will put pressure on rupee.

FIIs turning bullish on India?

That India's fiscal deficit is a worrying factor for the government is quite well known. The current government has been on a mission to bring this down as per targets stated. But while revenues may not have really risen much, much of this reduction has been through cutting down expenditure. And in many cases, planned expenditure required for developmental activities has also been slashed. That is why Planning Commission deputy chairman Mr Montek Singh Ahluwalia has proposed redefining the fiscal deficit targets altogether.

According to him, one should consider the primary deficit and not fiscal deficit. This is because primary deficit does not consider interest payments which according to Ahluwalia can vary for reasons which are not connected to the current fiscal discipline. According to us, the practice of redefining fiscal deficit targets will not really solve the core problems that have led to a bloated deficit in the first place. Further, whether Mr Ahluwalia's suggestions will be taken seriously remains to be seen given that general elections are just around the corner. After that, it will be up to the new government to set targets on this front.

We are sure each one of us would have heard about forest fires at one time or the other. Some of these are so devastating that they last for days together and destroy almost all vegetation in its wake. Therefore, we would of course be inclined to think that such fires should not happen at all. Mother Nature however, has an entirely different take on the issue. And from her perspective, these fires are actually a good thing if one takes the long term into account. Simply because they help get rid of the entire deadwood in the forest and pave the way for a totally new ecosystem. A system that is much more productive and efficient than its predecessor. Consequently, from this point of view, fires are actually a vital link and simply cannot be done away with.

Well, economies are no different we believe. And a recession or a crisis plays the same role here that the fires play in the forest. A crisis is a time for bad or inefficient businesses to face liquidation so that the capital can be deployed elsewhere for more productive purposes. As a result, crises are a must and should be allowed to take their natural course. Any interference here by the Government is certainly not good for the economy from a long term perspective.

We therefore read with great disappointment news in a leading daily that the European Central Bank wants to fight deflation at all costs. And is even willing to do whatever it takes to control the same. However, this as we just noted, could be damaging over the longer term. It is akin to stopping the forest fire in its tracks. All it will end up doing is invite a disaster of even bigger proportion somewhere down the line.

From their speeches and appearance, it would seem that the heads of central banks are the most confident and self assured people in the world. After all, they seem to be in control of the economy and never give the impression that there is anything to be worried about. Does this mean that it's true? To find the answer, one needs to only look at their track record. It paints a different picture. Before the global financial crisis of 2008, all central bankers had professed that the global economy did not face any risk. They had assured markets that the fears of a blow up were unfounded. Yet, a blow up was exactly what happened. This time around too, central bankers are completely silent about the increasing risks faced by the global financial system due to their policies. The reason for this silence could be the simple fact that they do not have a good understanding of the risks. The world economy is very complex and interconnected, more so than in 2008. If they did not understand the risks then, what are the chances that they do now? It is far more likely that their confidence is fake. They have no choice but to put up a brave face, lest their display of concern makes their worst fears come true.

Interestingly, the entire debate about investments these days gets centered on stocks and once-in-a-while around bonds. With the indices near lifetime highs, stocks undoubtedly are eliciting a lot of interest. Bonds and debt instruments too tend to get their place under the sun when investors are worried about stock valuations. However, what investors seem to be ignoring completely is an asset class called gold. Gold's underperformance versus other asset classes has played no small role in investor averseness to the metal. Add to that the higher import duty and curbs placed by the government on gold purchases. However, it seems that the central bank is rethinking its gold import policy. As per Firstbiz, the RBI may soon remove some of the curbs on gold imports. Especially since the rupee's appreciation has eased some concerns on current account deficit. And that could mean lower gold prices in a couple of months. Well, whether investors should buy more gold then or not will depend on their asset allocation. But it would certainly meaningful to hold at least 5-10% of one's assets in gold.

In the meanwhile, the Indian stock markets that had opened weak, continued to remain in the negative territory. At the time of writing, the benchmark BSE-Sensex was down by 77 points (-0.3%). Majority of the sectoral indices were trading in the red with auto and FMCG leading the pack of losers. Realty and consumer durable stocks were among the few stocks trading positive. Asian stock markets were trading negative with Indonesia and Singapore being the major losers. Most of the European markets opened the day on a strong note.

04:50  Today's investing mantra
"You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets." - Peter Lynch
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2 Responses to "Is Sensex at 18x fairly valued?"

Aniket shah

Apr 4, 2014

Sense isn't the benchmark any more.. sense or nifty.. is skewed towards IT and pharma. . Such an index of IT and pharma is at somewhere around 44000.. where are metals... banks.. cap goods? Have all these companies not grown in last 5 years in terms of earnings?.. They are cheap and ppl will buy into such companies and indexes will go up unless defensive go down


Manjunath Mariyappa

Apr 4, 2014

Dear Sir,

Thank you very much for publishing a unbiased review of the Current Stock Market.
After loosing heavily in the stock Market lesson learned is not to get carried away by speculations and wait for stock market declines.

After reading your article I currently do not have Gold in my Asset class since the GOLD ETF price has come down I will definitely buy it in small quantities..

Thanks and regards,

Manjunath Mariyappa

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