In despair and hope
Though the market is in a corrective phase, the nascent earnings recovery is fuelling investor optimism

Volatility has returned to the Indian market after a prolonged spell of ultra low volatile moves, in which the market largely remained in an upward trajectory, driven by huge liquidity.

The Nifty has gained more than 30 per cent over the past year and scaled new highs with low volatility. However, over the past month, the tide has turned. The much-feared correction has set in after the global market saw major selloff on fears of growing inflation and the spectre of interest rate hikes by central banks—ending their easy money policy. The India VIX, which measures investors’ perception of near-term volatility, touched a multi-month high last month.

The comments of new US Fed chief Jerome Powell were virtually a reiteration of the central bank’s previous policy stance, which has again rattled the bulls across the globe. Experts feel that if the 10-year US treasury bond yields go beyond 3 per cent, that may trigger a massive fall in stocks across markets.

The domestic market has been on the edge in the past few weeks. In fact, the Nifty closed below its 50-day moving average (DMA) for the longest stretch in February. The Nifty had, after crossing the 50 DMA in January 2017, gained 34 per cent to peak on January 29, 2018. After that the index closed below its 50 DMA for 16 days in February, against six days in December, indicating growing weakness in the market.

Apart from the global headwinds, multiple domestic factors are fuelling the market weakness. The biggest concern is the valuations.

Despite the recent correction, many experts feel that valuations of the Indian market and stocks are still on the higher side and the process of normalisation of multiples may have just started. They expect equity multiples to correct over time if the ongoing global economic recovery leads to higher inflation and bond yields. India faces country-specific macro and political risks over the next few months, which may force faster ‘normalisation’, analysts said.

“We find the valuations of the Indian market to be full and the macro quite uncertain to take a more constructive view of the market despite the recent correction,” Kotak Securities said.

“We note that the Indian market’s multiples already bake in strong earnings growth in FY2019E (26 per cent in the case of the Nifty-50 Index and 29 per cent for our coverage universe). However, we do not believe the Street has realigned its cost of equity assumptions to higher interest rates. Thus, there could be more correction in multiples (price correction or time correction) as the market realigns its cost of equity assumption to more realistic levels,” it said.

Many analysts expect the correction to be deeper and prolonged and advise that investors will be better off staying away rather than jumping in as stocks fall.

“We do not see the small correction in the large-cap names and meaningful correction in the mid-cap ones as a buying opportunity in general as we still find valuations on the higher side,” Kotak Securities said. The Indian market and most sectors are trading at well above their long-term average multiples, which would suggest that the equity market believes that (1) the recent spike in bond yields is temporary and it can continue using a ‘low’ cost of equity, as it had used implicitly in the past and/or (2) earnings growth will surprise positively, a tall order. The gap between bond and earnings yields looks ominous.

“It is time to be cautious and wait patiently before investing. Profits can be booked at every rise. The longer term trend is under pressure,” says Jimeet Modi, founder and CEO, Sacco Securities.

However, the excellent GDP numbers for Q3FY18 at 7.2 per cent, driven by the growth in agriculture, manufacturing and construction sectors, hold a glimmer of hope for the market. Though this number comes on the back of a low base of demonetisation quarter Q3FY17, it signifies that the economy is recovering and expanding at a reasonable speed before picking up pace in the near future.

According to analysts, the Central Statistical Organisation (CSO)’s upward revision of real GDP and gross value added (GVA) growth estimates affirms visible signs of an underlying improvement in the economy. The pickup in the quarterly GVA growth was largely witnessed in manufacturing, construction and agriculture. In the backdrop of a gradual recovery, analysts expect the RBI to maintain status quo on rates, at least in the first half of this calendar year.

The economy has started to recuperate from the cyclical and structural bottlenecks witnessed over the past two years, as reflected in the activity indicators, high frequency data and strong corporate earnings.

While the gradual improvement in private investment supports the hope of a revival in the capex cycle, the spare capacity in the economy, along with a slow resolution of the twin balance sheet problem, are expected to constrain growth in FY2019.

If improvements in the macro factors trigger corporate earnings growth and private capex, then things augur well for equity investments.

However, corporate earnings for the third quarter, after beginning on a strong note, lost sheen towards the end, led by disappointment from heavyweights like SBI, Tata Motors, Lupin and ONGC. Still, analysts are happy that the earnings picture is getting brighter and the recovery could gather pace in FY19. A bright spot is the recovery in consumption-oriented sectors, with broad-based volumes pick-up in staples, discretionary, cement and auto sectors, albeit on a low base of demonetisation, and upbeat commentary on rural consumption.

There are signs of a recovery in order inflow for infrastructure, construction and capital goods companies after the GST- related pangs of 2Q eased. The optimistic commentary by the IT sector and 3Q beat by tier-II IT names are also backing up the recovery hope.

There is also moderation in the quarter-on-quarter earnings downgrade/upgrade ratio as 65 companies saw earnings cut of 3 per cent-plus (58 in 2Q) and 43 saw earnings upgrades of a similar scale (49 in 2Q). The upgrade/downgrade ratio weakened from 0.84x to 0.66x during the two quarters.

“The earnings estimates for FY18 are relatively more stable vs FY15/16/17. We expect Nifty EPS to grow 13 per cent to Rs 471 in FY18 and 26 per cent to Rs 595 in FY19,” Motilal Oswal Securities said in a recent report.

Still, investors have to wait for the ongoing correction to bottom out before jumping in for bargain hunting.

Ashwin J Punnen