Earnings or sentiments: What will drive markets? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Earnings or sentiments: What will drive markets? 

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In this issue:
» Gold: No more a preferred asset class?
» What will be the new government's stand on gas prices?
» High expectations set in for the Indian realty sector
» Indian stocks outperform their Asian peers in the week gone by
» and more....

00:00  Chart of the day
Yesterday the markets seem to have gotten what they wanted. Despite that, the BSE-Sensex closed lower by over 1,250 points. Lower than the intraday high of 25,375 points that is. As compared to a day earlier, the index ended higher by only 0.9% or 216 points.

Does this indicate anything?

Well... from the surface, one could say that the expectation of favorable election results was already priced in. With valuations of the benchmark index at 18.8 times (on a trailing twelve month earnings), stocks are not cheap. Nevertheless, they don't seem to be in the overpriced territory as well.

When taking one-year forward growth assumptions into picture, the view remains the same. The index's EPS stands at Rs 1,283. Assuming a 10% and 15% rise in earnings, the Sensex is trading at a forward multiple of 17.1 times and 16.34 times respectively. Compared to the long term average of 16.7 times, the index is fairly valued. There is no doubt that the earnings growth rates have slowed down in recent years. And for the Sensex to justify valuations at such levels, earnings growth rates will need to pick up.

With elections coming to an end, the focus will shift back to fundamentals; earnings growth and earnings quality, in other words.

On a broad level, it all boils down to high expectations from the BJP-led NDA coalition.

And the expectations are quite demanding we must say. Economic revival, more jobs, lesser corruption, quicker governance, no policy paralysis, and large scale reforms - just to name a few.

As highlighted in yesterday's 5-Minute Wrapup the new government will need to tackle four major issues as soon as it assumes office. Apart from bolstering economic growth reducing fiscal and current account deficits will be essential as well. The last being controlling inflation levels, a major hindrance to the Indian economy in recent years.

In an interesting article authored by Ruchir Sharma, a comparison was made to Modi's current situation with that of President Reagan coming in power in 1980. At the time, the US Fed was being headed by Paul Volcker, who was considered as a strong inflation fighter. The latter is being compared to RBI governor Raghuram Rajan.

To fight inflation, it would be required for Modi to back Rajan. Despite all pressures - which included rising unemployment for a few years - from various parties, Mr. Reagan stood by Mr. Volcker's stand. At the end, Mr. Reagan was rewarded with a disinflationary boom and a landslide re-election in 1984.

Other key expectations include de-regulations, which basically focus on curbing expenses in counterproductive areas and in the process funneling resources on industrialization. Scrapping reckless spending programs would be a way to do so.

What is the way forward for Indian economy?
* - IMF projections

Today's chart of the day shows India's GDP growth rates over the past decade. After years of growth rates in excess of 7%, India's economy expanded by 4.5% in FY13 and is expected to grow at a marginally faster growth rate of 4.6% in FY14.

For bolstering growth, emphasis on manufacturing would be key; increasing the share of the currently 'in slump' sector would be essential. Not only for propping up growth levels but also to absorbing the large pool of eligible people seeking jobs. As pointed out by Mr. Sharma, the sector accounts for about 15% of the India's GDP. This is much lower when compared to 25% to 35% seen in rapidly industrializing economies.

In conclusion, with expectations set very high from the new government coming into power, all eyes will be on what moves the government makes in the short run. Considering that the economy is still not out of the woods, and a lot of pain points requiring resolution, the possibilities of stocks remaining quite volatile in the short run are quite high. Investors are recommended not to get carried away by sentiments, and rather focus on fundamentals as the latter would be critical for creating wealth over the long term.

Are the markets being driven by sentiments or fundamentals? Let us know in the Equitymaster Club or share your comments below.

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Well, we've talked a great deal about the impact of the new Government on stock prices. However, what about other asset classes like gold? Will the Modi effect come into play here as well? If a leading daily is to be believed, this impact is likely to be in the region of 10%. In other words, experts in the gold industry feel that gold prices have a real possibility of going down by another 10%. This has been assumed against the backdrop of further strengthening of the rupee against the dollar and also the formulation of favourable policies that will reduce the allure of gold or maybe increase its supply. Well, just as in stocks, it will be too early to come to conclusion of this sort in the case of gold prices too. Besides, while stocks move up or down based largely on what happens within Indian borders, gold prices are dictated by global geo-political and economic factors. And as far as these are concerned, there is hardly any palpable improvement here. Therefore, the fall in gold prices could actually be an opportunity to scoop the asset on the cheap. This provided it forms not more than 10%-15% of one's portfolio.

Stocks from the power sector were amongst the worst affected by the lack of reforms and government's indifference to structural bottlenecks. Issues ranging from supply of coal at reasonable rates, to power tariffs to poor health of SEBs plagued the fortune of power producers and distributors over past 5 years. The change of government may help kickstart some reforms which will trigger improvement in fundamentals of power companies. However, the reforms will not remove the bottlenecks for the sector overnight and earnings growth will filter in only over a period of few years. Even if issues like coal supply and power tariffs get resolved reasonably sooner, the health of SEBs alone will take about 3 to 4 years to improve. Hence investors need to be very cautious about rewarding rich valuations to the players in this sector in anticipation of superior growth.

Oil and gas sector, despite being the backbone of the economy, is one of the worst victims of Government regulations. The biggest issue in the sector is huge reliance on imported oil. The country relies on crude oil imports for more than 70% of its oil requirement. Structural issues like shortage in domestic gas supplies, macroeconomic variables like global crude oil and gas prices and rupee's value versus the dollar keep impacting the prospects of the sector. On top of that, fuel prices in India are not market determined. Over last year, some of the reforms such as phased deregulation of diesel have kicked in. However, there is still a long way to go with regards to structural and policy reforms. And now with a change of the Government at the centre, expectations are huge for a turnaround in the sector.

One of the key events to watch out for is the new Government's stand on gas prices. There are multiple stakeholders with conflicting interests as far as gas price hike is concerned. Even if the gas prices are hiked, it will not guarantee an increase in the domestic gas supplies. Meanwhile, global gas prices, crude oil prices and exchange rates will continue to impact domestic oil and gas companies. Nonetheless, the regulatory environment seems better than that in the past. Overall, the prospects of oil and gas sector, though far from ideal, have significantly improved. The proposed regulatory reforms, if implemented in letter and spirit, are likely to lead to a structural up cycle over the long term.

Real estate sector is muddled with bureaucratic hurdles. Lack of regulatory oversight leaves enough grey area for corruption. However, with a pro-business, no non-sense leader registering a thumping victory in the general elections there are expectations that the ease of doing business in India will improve. While this may benefit all sectors that were ingrained in bureaucratic deadlock it would be interesting to see if real estate will stand to benefit from increased transparency. There are questions over it because this is the sector where politician-builder nexus prevails to a large extent. Hence, a greater will and tougher regulations are required to revive the faith of investors. And this is where most people will have expectations from the new government who won this election on development poll plank. It would be interesting to see if the new governance model of the NDA government will help the real estate sector or not. While there are expectations that it will which has been reflected in increased stock prices it is the execution that matters. And this shall be the main challenge of the new government.

Any upturn in economic cycle definitely boosts the performance of the banking sector, which is considered to be the barometer of the economy. And it is well-known that the banking system today is grappling with the chronic credit quality issues. Corporate borrowers have failed to honor loan commitments to lenders on account of weak investment cycle, higher interest costs and policy logjam. Therefore, faster tackling of the surge in bad loans in the banking system in light of improved governance is something to be watched out for. Moreover, the need for capitalization for few public sector banks will also be on the radar of the new government in power. As the Indian banking system gradually moves towards adoption of global banking practices, it would be interesting to note the shaping up of the relationship between the new government and the central bank. We certainly hope the central bank's autonomy is retained in light of appropriate decision making power in terms of macro-prudential requirements and monetary policy framework. As this will go a long way in building up a strong and sustainable financial system.

Against the backdrop of anticipated policy changes and improved growth dynamics, we reckon stocks from the banking and financial services sector to be in favor in the near term. However, we would like to remind our readers to be cautious about the medium term gyrations and invest only in companies with strong long-term fundamentals and stable management.

The capital goods sector, one of the most instrumental sectors in India's economic growth, has been facing a slowdown since last few years due to government inaction. The new government is expected to provide a new lease of life to the tumbling industry. Issues such as land acquisition, environment clearances and lack of funds are expected to be tackled. However, the markets seem to have factored in the positivism to a large extent. At the same time, working at the ground level to solve inherent issues may take longer than anticipated. Therefore, from a long term perspective investors are advised to look at stocks with strong moats, good revenue visibility and low leverage. Also, companies which can grapple with other challenges such as increasing Chinese competition and over capacity within the industry should be preferred.

Indian markets have outperformed all equity markets across the world in the week gone by. All the Asian indices - except Indian - ended on a flat note this week. The selloff in Asian markets was followed by cues from the US markets on account of a weak economic data. Industrial production which measures the output of US manufacturers, utilities and mines, dropped by 0.6% on a month on month basis in the month of April. This was against expectations of a 0.1% drop.

Coming to domestic markets, the Sensex jumped 4.9% this week following the election euphoria in expectation of a stable NDA government. Exit poll results earlier this week set the tone for record level jump in key indices. Investors lapped up stocks in bank, power, infrastructure and real estate sectors.

Performance during the week ended May 16th, 2014
Source: Yahoo Finance, Kitco

04:55  Weekend investing mantra
"Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere." - Warren Buffett
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1 Responses to "Earnings or sentiments: What will drive markets?"

Sundaravaradan S

May 17, 2014

Pls.Ref to the Webinar.

We need to be pragmatic in our Advice: Neither of the Extremes!
We need to preach, only those, we practice. (Does Quantum funds keep, at present, 40 to 60 % in Cash?? (That webinar advised).

Caution is important; over caution to the extent of Negativity will kill the Investors!

If SENSEX grows from 24000 to 30000 in 4 years, it is CAGR of 6% only! Is it too much to expect? This is assuming PE of 18 during Modi's Reform! Is it too much.

We expect EQM to Professional Advice (Not with feelings of HURT by SEBI).
Yes; you may like to refute?

Unlike, Congress, I think, EQM will think & answer!

Equitymaster requests your view! Post a comment on "Earnings or sentiments: What will drive markets?". Click here!


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