The real reason why Sensex could correct in next 12 months - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

The real reason why Sensex could correct in next 12 months 

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In this issue:
» Can India be the next China under Modi's leadership?
» Rupee is on a meteoric rise
» Has the bear market in gold begun?
» In the next five years US to face a financial crisis worse than that of 2008
» ...and more!

00:00  Chart of the day
Indian stock markets have been on a rampage ever since the electoral verdict came in favour of the NDA government. Especially sectors mired with bureaucracy have seen strong gains over expectations that decisive leadership at the Centre will unleash a slew of reforms to revive a flaccid economy. Brokerages have been coming out with optimistic Sensex targets and there is a renewed optimism on the street.

There is a general belief that the market is in a sweet spot and will rally from here on as sentiments are bullish. Retail investors who were circumspect to invest earlier are feeling left out and are ready to jump in to the market. In fact, we have also received quite a few emails questioning why there are no BUY recommendations when markets are peaking every day!

We believe this is that classic period where stock markets ignore fundamentals and are driven by sentiments which is reflected in investors' urge to buy. But this is where retail investors have to be more cautious to not fall prey to a buy high syndrome.

Any decision to buy or not is governed by fundamentals & valuations and not sentiments. And valuations of Sensex companies do not reveal an exciting picture. Have a look at the chart below.

Is the Sensex overvalued at current levels?

As can be seen from the chart, the average trailing twelve month (TTM) Sensex P/E has been 18.7x over the last 10 years. And the current TTM P/E is 18.0x. So, if the past valuations are a benchmark the Sensex is in the fair value zone at the moment even after pricing in the election verdict.

As such, an upside from here on will depend upon two factors. Either the multiple or the earnings will have to expand. Expansion of multiple appears to be a remote possibility as Sensex is trading close to its benchmark valuations.

So, will the earnings expand? Let us have a look at the historical Sensex earnings growth to get an idea. Please note that we have used standalone earnings for the purpose of our analysis. And most Sensex companies are conglomerates with number of subsidiaries. As such, there will be a difference between the standalone and consolidated EPS figures of Sensex.

Will earnings play a catch up?
Year Standalone Sensex EPS (Rs ) Earnings Growth (%)
FY09 889.5 5.8%
FY10 1126.3 26.6%
FY11 1297.3 15.2%
FY12 1395.3 7.6%
FY13 1527.2 9.4%
FY14 ? ?
Data Source: Ace Equity

As can be seen from the above table the earnings growth in the FY12 and FY13 has been in single digits. And FY14 is likely to be no different. But despite this markets have been rallying.

However, one may argue that markets are pricing in one year forward future earnings potential. This effectively indicates that recovery is priced in and if the double digit earnings growth does not materialize valuations may correct. Allow us to explain. Despite earnings expected to remain subdued in FY14 markets are trading at mean P/E valuations. In a way it reflects that markets are pricing in mean earnings growth for FY15. And the historical earnings CAGR over the last 5 years stood at 14.5%. So, if in FY15, earnings growth is grossly below historical CAGR markets may correct.

As such, the risk reward ratio is not completely in favour of long term investors now. Hence, we would recommend investors to be extremely cautious while investing in markets. During such times one has to be stock specific. Buying based purely on sentiments can lead to suboptimal results in the long run.

Do you think this is an opportune time to invest in markets? If yes, what gives you confidence that markets will rally from here on? Let us know in the Equitymaster Club or share your comments below.

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So, the BJP led NDA has got the mandate to form the new Government. And experts are now busy projecting the fate of the economy under its charismatic leader Narendra Modi. The international news media giant, CNN is the latest to jump onto this band wagon. It has asked whether the new Prime Minister of India has it in him to put the economy back on track to rival China. Well, there's no doubting that the country does have the potential. Especially in light of its vast natural resources and one of the youngest population in the world. However, what is impacting us the most is abysmally low productivity levels, especially in manufacturing. And therefore the biggest challenge before Modi would be two-fold. Not only create more jobs in manufacturing but also take the productivity higher by fostering competition and reducing red tapism. He has certainly shown signs of doing this during his stint as the Chief Minister of Gujarat. And we could certainly see the return of 8-9% GDP growth if he is able to replicate some of that at the centre too.

Even as the election euphoria settles down, equities continue to find favour amongst investors in India. The sentiments in Indian markets have clearly moved from a doomsday scenario to one of unprecedented hope. Needless to say, gold, which is considered to be an asset for difficult times rather than good times, is finding fewer takers. That the RBI has relaxed curbs on importing gold has also had an impact on gold prices. It may be recalled that in July 2013, the government had insisted on reining gold imports. This was primarily in view of tackling the swelled current account deficit and weak rupee. So the RBI had banned gold imports by trading houses for sale in the local market. They were allowed to import only for re-exports. With the appreciation in the rupee, the RBI has once again allowed key trading houses to import gold. The improved supply is expected to keep gold prices lower. However, we believe, investors should use the short term correction in gold prices, as an opportunity to buy. Especially, if they do not have at least 5% of their portfolio in the yellow metal yet. For, going by global risk cues, the need for a safe haven asset in the portfolio is far from over.

The rupee has been gaining steadily ever since expectations rose on the BJP coming into power. Those expectations were met when the BJP secured a clear majority to the form the new government. This has further bolstered the rally in the currency. And now the latest catalyst appears to be on the fiscal deficit front. As per an article in the Business Standard, the finance ministry is working on a proposal to cut fiscal deficit. Its aim is to bring the deficit down to 3.8-3.9% of the GDP as against the earlier target of 4.1%. We believe it is the step in the right direction but it will be interesting to see how the government intends to go about this. Meanwhile, the RBI has been buying up dollars so as to arrest any sharp gains in the rupee. The idea is to ensure that exports are not impacted by the appreciation because it will once again have some impact on the current account balance. But, we believe that in the longer run if the NDA government delivers on its development agenda as a result of which the GDP growth once again picks up, the rupee will eventually gain value.

The financial crisis in 2008 that shook the foundations of the global economy is not yet entirely out of our memories. And those who think that the worst is already past us may get an ugly shock in a few years from now. As per James Richards, the bestselling author and senior managing director at Tangent Capital Partners, a financial crisis of even bigger size is likely to strike the US within 5 years.

And he has some convincing reasons to believe so. The Fed interference saved a lot of financial firms in 2008 crisis. However, the solution has been just cosmetic and the system has not healed. The bad debt and leverage levels in US are higher than before. One should note that these were some of the main reasons for the crisis in the first place.

And as far as the rescue efforts are concerned, considering even bigger size of these financial institutions and abuse of monetary easing, it will be really difficult to arrest the damage this time in case a crisis strikes.

The Indian stock markets, pared gains but continued to trade above the dotted line. At the time of writing, the benchmark BSE-Sensex was up by 143 points (0.6%). Barring consumer durable and banking, all sectoral indices were trading in the green. Power and capital goods stocks were the biggest gainers. Most of the Asian stock markets were trading in the green with Japan and China being among major gainers. European markets have also opened the day on a firm note.

04:50  Today's investing mantra
"Bad things aren't obvious when times are good" - Warren Buffett
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4 Responses to "The real reason why Sensex could correct in next 12 months"

ajmer hundal

Jun 2, 2014

The sentiments are euphoric and bullish. Modi does not have a magic band to improve the GDP and control CAD. Foreign exchange jitters cannot be fine tuned in a whiff. Bad things aren't obvious when times are good" - Warren Buffett and that is going to happen with India. We Indian are by nature gullible and boisterous to exaggerate. Market will fall like a nine pin prior to Budget itself.

Like (1)


May 24, 2014

Sir your most of recommendation is from small cap but for article you have chosen Sensex. No doubt penny stock are in lime light and it need to be cautious but at the same time this is the right time to pick the GEMS and for that only we have associated with u.

Like (2)


May 23, 2014

Be fearful when other are greedy. I guess everyone's being too greedy. Mr. Modi can't and won't run each business himself. Surely he will work to make things better but his results will take at-least a year or two to show up and the fidgety traders aren't programmed to be patient so they will deliver a nice plunge in 3-6 months investors can wait and step in then.

Like (2)

Sharukh Doctor

May 23, 2014

I am sure that the earnings in FY 2014-15 will grow by at least 10% taking the Sensex EPS to 1680 and because of the strong sentiments and hope rally the sensex P/E will be at least 20 if not more. This will take the sensex to at least 33600. Hence range of 31000 to 35000 is a distinct possibility.

Like (2)
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