AB KI BAAR 28 HAZAAR

A stable and decisive government is finally in place at the centre. The force with which the BJP led NDA has assumed power is unprecedented so to say. The overall environment has changed from being one fret with lack of decision making and proper policy initiatives to a supercharged one where anything and everything suddenly seems possible to achieve. With a young and dynamic cabinet being sworn in under the leadership of Shri Narendra Damodardas Modi as the Prime Minister, hopes of a real turnaround in the fortunes of the country both economically and socially have reached a crescendo.

The equity market is the best barometer to measure the optimism or pessimism surrounding any event. The way they have been behaving over the past couple of months gradually pricing in, first, the hope of a strong and stable government, and now, the expectations from such a strong and stable government that it has come to power purely exemplifies this. Expectations of the better days to come have once again ignited the equity market big time. This is reflected in the movement of the benchmark indices. The BSE Sensex is already up by 17 per cent year-till-date at 24716 (as on May 26) and most of this gain has come since May 12 when the last round of voting was done with.

The buck does not stop there, barring a few indices, all the sectoral, mid-cap and small-cap indices too are up anywhere between 17 to 45 per cent. According to Dinesh Thakkar, CMD, Angel Broking, “A stable government with a full majority definitely bodes well for a country which is at cusp of the growth curve and needs steps to carry out reforms to spur growth and remove bottlenecks”. This tells you the roots of the optimism and the expectations from the new Government.

This spectacular run by the equity market has prompted various participants to predict the Sensex to cross 28000 by the end of CY14. This means the Sensex is expected to gain a huge 32 per cent in CY14 and 14 per cent from the current levels. From a historical perspective this does not look a tall order as the benchmark has achieved this feat seven times in the last 33 years starting 1990. Most recently, in 2009, the Sensex went up by a huge 76 per cent. Cynics are likely to argue that this gain had come after a fall of 52 per cent in the year 2008.

Nonetheless, there are more examples like 2005, 2006 and 2007 where we witnessed the benchmark index moving up by more than 40 per cent in succession. “We must recognise that there is a possibility of achieving in 60 months what we probably did not achieve in the last 30 years in coalition politics” explains K Sandeep Nayak, ED and CEO, Centrum Retail Broking. That too speaks a lot about the confidence that people have in the new dispensation.

So, here is Dalal Street Investment Journal’s view built on various interactions and our own strong research of fundamentals and technical’s which will tell you why and how the Sensex will hit the magical 28000 mark and move beyond it over the remainder of the year.
[PAGE BREAK]

GDP Growth Rate and equity returns 

Conventional wisdom holds that equity market returns are not linked to GDP growth in the short term. Even various researches fail to find positive correlation between GDP growth and equity returns in the short run. This gets clearly reflected more so in the Indian context. We ran a regression analysis between GDP growth and Sensex returns since 1994 and could not find any significant relation between the two. For example in 1995, the BSE Sensex gave a negative return of 20 per cent despite economy growing by 7.6 per cent (all the figures are on calendar year basis). More recently, in 2011, the economy grew by 6.6 per cent and the Sensex returned a negative 25 per cent. There are more cases like these when we have witnessed the equity market returning above their long term average despite the GDP growing below its long term average. For instance, in the year 2010 when we saw the economy grow at a scorching pace of 10.3 per cent, a frontline index like the Sensex moved up by only 17 per cent. So what explains this conundrum?

Equity markets are forward looking and hence it is not the actual GDP growth in any given year that drives the equity performance but the expected growth of GDP in future plays a larger role in determining the equity market returns. Therefore in 2009, the bellwether index moved up by 80 per cent ahead of a 10.3 per cent GDP growth recorded in 2010. Changes to the consensus expectation for future GDP growth is taken into account by equity investors, thereby determining current year returns, rather than the current year GDP growth rate. With a new pro-reform government coming into power at the centre, has clearly rekindled hopes of faster economic growth ahead. Many Indian and foreign brokerages have already upgraded their GDP growth rate expectations post election results. If the GDP growth rate for FY14 is printed below five per cent (which looks like a strong probability), it will be the second year in succession when we would have seen GDP growing below the five per cent mark. Nonetheless, after recording a lower GDP growth in the last fiscal, for FY15 and FY16 the consensus estimates for the GDP growth stand at 5.5 per cent and 6.5 per cent respectively. There are some who expect the economy to accelerate at a much faster pace. “As far as FY2015, is concerned; we expect the economy to grow at 6 – 7 per cent” says Thakkar.

A faster economic growth leads to a surge in consumer demand explains a report by CRISIL, (a global analytical company providing Ratings, Research). According to the report, “at 9 per cent growth over the next five years, compared with 6.5 per cent, two million more cars and ten million more two-wheelers would be sold, among other things”.

It has also been observed that faster economic growth leads to above average growth in corporate earnings. A slowdown in economic growth leads to corporate profits falling at a faster pace. For example, during the year CY04-CY10 when the average GDP growth was 8.4 per cent, corporate profits increased at around 19 per cent every year. However, when the growth rate dipped to around an average of five per cent in the following three years, corporate profits grew by a mere three per cent. This has led to expectations that corporate profits may drop from 7.8 per cent at the end of FY08 to around 4.2 per cent at the end of FY14. The fall in the profit was mainly driven by PSU banks and cyclicals like capital goods, cement and real estate. And, if the economy picks up, the same sectors that have led to the fall in the overall earnings will help to revive the growth in earnings. Since FY03 the ratio of corporate profits to GDP has remained at an average 5.6 per cent. It is likely that this ratio will revert back to its mean by FY18, implying that net profit will record a CAGR of 22 per cent in the next four years. (More on earnings in the latter part of this article). A stable government can fuel a business friendly environment and domestic demand that in turn will help to accelerate GDP growth, which in turn will help earnings to recover.
[PAGE BREAK]

Tackling Roadblocks

Taming the Inflation Monster

Regardless, the path of achieving GDP growth of even 5.5 per cent by FY15 is not smooth and is full of roadblocks. Higher sustained inflation remains one of the biggest headwinds. Inflation has constantly remained above the comfort zone of Reserve Bank of India for more than couple of years now. The situation gets more complicated as of now, because of the hailstorm which recently occurred in various parts of the country and the likely occurrence of El Nino, which has the potential of altering the monsoon to below normal.

Nayak agrees to it and said, “This country still depends on rain gods. There is also a talk of the El Nino affecting the Indian crops. That is one risk because when that happens, it has a lag effect and inflation will start to go up in the early part of next year. With food & food products carrying higher weightage of around 48 per cent in consumer price index (CPI) inflation, surge in the headline inflation cannot be ruled out and hence controlling inflation will remain a major headwind for new government.

Higher inflation hinders an economy to achieve its potential growth rate. If RBI continues with its six per cent CPI inflation target recommended by Urjit Patel Commission, before taking any action on policy rates, it may become a bone of contention between Finance ministry and RBI. Nonetheless, we believe that upcoming budget presents an excellent opportunity for the government to showcase its commitment on fiscal consolidation by reducing subsidies that will help to contain inflation. We believe that the budget will present at least a credible road map on this front, which will help apex bank to cut rates earlier than expected. A lower interest rate will definitely help to revive the investment cycle. The view is clearly expressed by Thakkar, “The main challenge, for the government is to curtail the inflation, which can then start the cycle of investments and hence growth.”

Investments To Help Growth Revival

One of the major reasons for weakness in the Indian economy in last couple of years was that, not enough was invested in infrastructure or otherwise. There is a direct link between investments and GDP growth. What is also interesting to note is that, investment has contributed more than private consumption in stimulating greater GDP growth despite the share of consumption in GDP being more than that of investment. It is expected that the new government is likely to get project clearance and implementation expedited. According to a report by IMF, ‘policy uncertainty’ is one of the key driving forces behind India’s precipitous slowdown in investment activities. Therefore, reducing regulatory uncertainty and simplifying procedures for obtaining clearances would be the priority of the government which will help in reviving the investment cycle. Sandeep Nayak elucidates, “If the investment cycle kicks off, that itself will give you half a per cent on GDP as investment spending resumes.” The initial statement given by the new ministers indicates their commitment in this front. One of the major hurdles to revive the investment cycle has been the widening fiscal deficit, which has crowded out the private sector investment.

Controlling Fiscal Deficit

Although the present fiscal situation is better than the crisis that we had during the financial meltdown when it had touched six per cent of GDP, the present figures are yet worrisome. Revenue receipts are below budget estimates, coupled with expenditure overruns, exerted considerable pressure during FY14 on India’s fiscal position. The fiscal deficit has already crossed the yearly target by Feb’14 and less-than expected advance-tax collection in Q4FY14 would prove difficult for the government to rein in the fiscal deficit within the revised, 4.6 per cent. Moreover, the cut down in the fiscal deficit in last couple of years has come down at the cost of cutting of productive expenditure by the government. The new government has to reverse the trend and raise the productive expenditure that will help to begin the virtuous cycle of higher investment, create more jobs leading to higher income levels. Looking at the past experience of the NDA government, we are sure that the government will control the fiscal deficit through cutting subsidies and expediting the disinvestment process.
[PAGE BREAK]

On The Valuation Front

The likely improvement in the above factors has definitely helped to boost the sentiment in the equity markets. Nonetheless, valuation plays an important part in moving the market. Rather it is the valuation which provides direction to the markets in long run after which liquidity and the sentiments usually play a second fiddle. Now in short term it may happen that the sentiments and liquidity help the indices surge to news levels, but eventually the markets get aligned with valuations. Nonetheless liquidity is also going to be supportive and we expect the inflows to be much healthier as we move forward in the year says Thakkar, “We had witnessed the same in 2008 when the markets were driven by excess liquidity and euphoria. And afterwards the global financial meltdown resulted in slower earnings growth, which then eventually leads to markets aligning to the right levels of valuation.”

Why are we talking so much about the valuations is that, in the last one year the frontline indices have rallied more than 27 per cent, while the earnings growth during the similar period has been less than 15 per cent. Hence it seems that there is surely a gap between the earnings growth and the rise in valuations. The gap has widened during the last one month as the Sensex and Nifty witnessed a more than 13 per cent gains with hardly any change on the earnings front in the March 2014, quarter and even the FY14 as a whole. Hence, the investors would be curious to know where the valuations are heading and ultimately providing the indices a sort of direction. So what are our estimates about the EPS growth and valuations going forward?

Before having a look at what the forward earnings would be, let’s understand how the markets are placed on valuations front at current levels. At current levels the Sensex is trading at 24500, which discount its trailing four quarter earnings by 18x. And this is in line with the historic averages. Rather, historically it is has been seen that, it is the expansion of P/E which takes the markets northward most of the times than the expansion of EPS and hence the current run up in the indices are no exception. If investors could recollect, during the last couple of bull run that is during IT bubble of year 2000 and in the year 2008 the indices even traded at price to earnings of more than 26x. Therefore, from historic perspective, valuations are not stretched and there is still scope of valuation expansion.

When asked to Motilal Oswal, CMD, Motilal Oswal Financial Services on valuation front he said, “I think that the markets are reasonably valued. Our estimate is in the next two years, the running growth will be around 16 per cent against 3 per cent in last 5 years. We are quite hopeful about the recovery and of profits going up. If that happens, I would say that the markets look quite reasonable.”

Moot question here is, markets usually discount the future earning and hence it is important to understand the expected future earnings growth.

The kind of performance India Inc has posted in past four quarters or FY14 as a whole does not shows any rosy picture. Sales volumes also failed to pick up momentum. The earnings hardly provided any positive surprises with margins remaining under pressure and a higher interest burden owing to higher leveraged balance sheet is taking a toll on the bottomline. As discussed above slower GDP growth, higher inflation and higher interest cost resulted in such a dismal performance of India Inc.

If that is the reason, then what is going to change and what will drive the earnings growth going forward? Now here at current levels JP Morgan Chase AMC has stated that, “ We believe India’s corporate earnings have bottomed out and that current valuations look compelling, especially for cyclical stocks where we believe a round of earnings upgrades is getting underway.”

We also agree to the views as the scenario is likely to improve with the change in government which would be taking the reforms forward. Hence, going ahead the GDP growth is like to pick up and would be around 5.5 per cent in FY15 resulting into earnings growth of around 15 per cent. The Sensex EPS is expected to be around 1500-1550 in FY15. Even if we consider the forward valuation of 18.50x, the target of 28675-29000 is achievable in next one year. Further this is a very conservative estimate and looks easily achievable.

While we have provided the figures for FY15, the Bloomberg estimates are provided for CY14 and CY15 also. For CY15 the EPS is estimated at `1581 showing an increase of 19 per cent. Again at 15x of CY14 estimates the Sensex levels stand at 27354 and with 18.50x the Sensex values emerges at 32825. We feel the actual values would be in between these two figures.

Therefore, Sensex touching 28000 by the end of year looks very likely. So what a retail investor should be doing? Motilal Oswal advices retail investors to, “drastically increase their equity allocation and remain invested in good quality cyclical as well as growth sectors.” An analysis of returns by various sectoral as well as mid cap and small cap indices since year 2011 shows that it is the beaten down stocks that are all set to show a better performance, whereas defensive sectors like FMCG and Health care are showing signs of tiredness. Thus, retail investor should take this opportunity to build their portfolio and should pick up stocks fundamentally and avoid panic buying.

What Technicals Says

The first half of year 2014 has been pretty melodious for the bulls where the Nifty 50 index has been moving from strength to strength and is scaling news highs with every passing day, such as even a correction is short lived and bears are caught on the wrong side in every dip. The Nifty 50 index has managed to gain just over 16 per cent year till date. This rally has been broad based as the contribution has come in from all the sectors from Banking, Steel, Auto, Realty, Power, and Oil & Gas etc., including the mid-cap and small-cap stocks.

On analyzing weekly chart we could witness that the index oscillated in a range for over five-six year and in this process the Nifty index formed a triple top pattern and this pattern is formed by joining highs of year 2008, which was around 6356, high of 2010 which was around 6338 and high of 2013. Nifty in month of March, 2014 witnessed breakout of this triple top pattern of five-six years and market saw one of the most incredible rally up to levels of 7564 which was registered on 16th May, 2014. Now that’s precisely an 1100 points rally from the breakout level and in span of two and half months. This rally has been described as “Modi” wave by the analysts.

Now the big question arises should we continue to remain bullish on Indian equities as the markets have moved up sharply in such a short span of time? Technically picture suggest that the bullish trend of the Indian equities market is likely to continue, as structurally Nifty is continuing its higher top higher bottom formation post the big breakout. If we calculate the target for Nifty of triple top pattern the next probable target for index is around 8200-8300 in long term. In short term the risk reward is not favourable as the momentum indicators (RSI) is about to touch its higher band and in short term pull back or retracement is likely. This retracement is the right time to enter the Indian equities keeping the potential long term secular bull run in mind. In long run 6300-6400 will act as strong support for the index and probably at current junctures this can be said the bottom for the index. Why 6300-6400 is an important support for Nifty in the long term is that, first the trend line joining important high of 2008, 2010 and 2013 is placed in this zone and second 6313 is 23.6 per cent retracement from entire move from 2252 to 7564. To summarize the Nifty index, it is likely to enter into a corrective and consolidation phase and post that the nifty index would resume its uptrend, so as to test our target price of 8200-8300.