INDIAN STOCK MARKET: WHAT NEXT?

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The Bull-run
The bull-run that happened during 2007 was due to USD 17 billion of foreign money that came into India which was mostly speculative money. Not long term capital that large pension funds invest with a 10 year and 20 year time frame. But quick, in-and-out money that hedge funds were happily gambling with. The swine flu of the western capitalist society had invaded India. Such “hot money” began to fund highly irrational ventures - like this concept of land banks accumulated by various real estate developers. But the injection of this money itself made the irrational, look rational. Every barren piece of land stolen from illiterate villagers was seen as a glossy township with billions of dollars of future cash flow.

The fall
The Indian stock markets wobbled from their January 2008 peak largely because of the fears of inflation. The price of commodities including oil and wheat had surged. India was seen to be a victim of a high inflation environment. When India did actually face a threat and problem from the global economic crisis and financial meltdown, the policy makers were helpless. And thus when the global crisis hit - India, one of the lesser affected economies - was one of the worst hit stock markets in the world. Market fell from 21000 levels to 14000 levels. But again the markets fell to 8,000 after September 15, 2008 when Lehman went bust. That is because the foreign hedge funds went scrambling back home with their cash. And there was no buyer to absorb their vicious selling.

The Comeback
The BSE 30 Index was stuck in the 8,000 to 10,000 range for 5 months between October 2008 and March 2009. But, after breaking the 10,000 barrier in March, the market marched on relentlessly to 12,173 on May 15th - the last trading day before the election results. And after the election results the index surged dramatically to 15000 plus levels. This rise was so rapid - and against the mainstream thinking - that most people were left out. In fact, many lost money by going "short" - betting that the markets would decline.

What next?
The BSE-Sensex has moved up by nearly 80% from the bottom. Back then, the index was trading at an attractive price to earnings valuation of 12 times. Presently it is trading at about 20 times. Historically, it is believed that the BSE-Sensex has traded at a price to earnings multiple of around 15 to 16 times. Therefore, if one wishes to view this from an FY11 perspective, considering that we expect returns of 12%-13% on a CAGR basis from the Sensex, the earnings of the companies that comprise the Sensex will have to grow at a CAGR of 27%. And therein lies the difficulty. For a GDP that is expected to log in nominal growth rate in the region of 10%-12%, a 27% CAGR in earnings looks a tall order indeed. Thus, unless there is a significant re-rating of the Sensex, where in the P/E remains the same or goes even higher, things do not look rosy for an investor from a FY11 perspective. He will have to rely on his stock picking skills to achieve any outsized returns.

The BSE-Midcap Index also has moved up by nearly 108% in the last three months. From a valuation of 9 times that it garnered during the first week of March, currently the index is trading at a multiple of 17 times. On the other hand, the BSE-Smallcap Index has moved up by 123% in the past three months and is currently trading at a price to earnings multiple of 14 times. Three months back it was trading at a multiple of 6 times. Although these indices are not as steeply priced as the Sensex, the upside, if any, is likely to be only marginal from the current levels.

Thus, unless earnings re-rate dramatically, fundamentals, at least in the medium term, point towards a correction of the magnitude of 20%-25%, which will again take us back to the fair valuation range.