Jun 21, 2005|
A thing or two about 7,000!
Investors seem to be enthused by the fact that the BSE-Sensex could touch 7,000 levels. Now, how is 7,000 different from 6,900 or for that matter, even 6,500 when it comes to investing in stock markets is anybody's guess. But for the stock markets, it seems to matter, psychologically!
To start of with, we would like to quote Sir John Templeton. He said, "Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria." This quote not only applies to the stock market but also to individual stocks and sectors as well. Take the case of NSE-Nifty first. The graphs below highlight the trend in price to earnings ratio (P/E) of Nifty Fifty and Nifty Junior indices since January 1999.
The average P/E ratio of NSE Nifty is 17 times earnings. But if one were to exclude January 1999 to December 2000 (being the tech bubble where valuations had skyrocketed to obscene levels), the average P/E ratio of Nifty works out to 15.6 times. Based on trailing earnings, the Nifty is currently trading at 14.1 times. If one were to assume that the average earnings growth of Nifty stocks in FY06 is 15%, the forwards P/E ratio stands at 12.2 times, which in our view, is not a level that should make one nervous. So, even if one were to invest taking into account a two to three year view, valuations are reasonable.
But, there are risks.
Monsoons: In light of the delay in monsoons, CMIE reduced its GDP growth expectations from 6.6% to 6.0% very recently. While the meteorological department still believes that the country will witness normal monsoons, the predictions of IMD have been as erratic as the monsoon itself! While much has been written about the impact of poor monsoons on economic growth, in our view, this will impact earnings growth of corporates. As per the latest data available from Ministry of Finance, almost 40% of meteorological divisions have witnessed deficient/scanty/nil pre-monsoon showers, which are one of the key factors for kharif sowing.
Inflation: As against the annual inflation of 3.5% in FY04 at the consumer level (CPI), CPI as of March 2005 stood at 4.2%. Now that the government had to finally resort to increasing petroleum product prices (petrol, diesel), we believe that inflation at the consumer end will start inching upwards. Consumers have been significantly protected till now and higher inflation at the consumer level could impact demand for goods. With crude prices showing no signs of softening, this issue remains sticky. However, any softening in other commodity prices like steel could bring some respite to the industry.
Interest rates: Although interest rates globally have been rising (Fed has been raising interest rates since June 2004), it does not seem to have a bearing on equity prices in emerging markets. Usually, tightening of monetary policy in developed markets results in excess liquidity being sucked back to where it came from. But this has not happened and investors believe that this time, it is different! But there is a caveat here. When the Federal Reserve of the US started raising interest rates in the previous cycle, the interest rate then was 3% (in the current tightening cycle however, interest rates was at 1% in June as against which it currently stands at 2.25% with more to come). With economists expect interest rates in the US to touch 3.5% to 4% by the calendar year end (another 1.75% increase from the current level!), we believe that the kind of money flow into Indian equities that one has seen in the last two to three years may not be repeated. At the end of the day, demand and supply governs prices. If demand slows, prices tend to retrace, everything else remaining the same.
Valuations: In our view, as we had mentioned earlier, the overall valuation is not expensive from a long-term perspective. But if one were to consider mid-cap stocks or select stocks from sectors like software, metals and engineering, we believe that valuations adequately reflect earnings growth prospects in the next two years. Irrespective of whether it is a bull market or a bear market, unless and until there are some fundamental changes, valuations do not change dramatically.
We would like to conclude this article by focusing on the index again.
Yes, the benchmark BSE Sensex has risen sharply in the last two to three months. But do you know that the Reliance group stocks alone contributed almost half of the gains!
Secondly, do the constituents of benchmark indices really represent the Indian economy? Weightage in the index is clearly skewed towards certain sectors/stocks. Add to this, the constituents of the indices changes every time the stock market goes up! One wonders what the actual BSE Sensex would have been if the index constituents were the same in 1997! Changes in the global benchmarks like Dow Jones 30 have been minimal.
Thirdly, the hype about the Sensex crossing 7,000 levels. While business channels and newspapers may go hung-ho about the same, one wonders what is the psychological factor here at 7,000. Investing in stocks based on these so-called 'psychologically levels' is fraught with high risk. We suggest investors not to invest now based on this premise. Ultimately, stock prices are governed by fundamentals in the long-term.
Does this mean we are bearish on the markets? The answer is a simple 'No'! Even now, we believe that there are good companies to invest with a two to three year time horizon. In this context, we do recommend stocks to our subscribers. However, our return expectations will be in the range of 15% to 20% per annum, depending on the risk profile. Having said that, we believe that the mid-cap madness will be tested going forward.
To reinforce again, "Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria" - Sir John Templeton.
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