Stock markets: Time to be cautious?

Leading business dailies have been opining a word of caution to their readers, stating reasons such as high valuations, the recent run up, speculation, amongst others for the market run up in recent times. This is our version of the discussion.

Source: BSE

As you may be aware, it was exactly three months ago, March 9 2009, that the pivotal point for the markets had arrived. The BSE-Sensex has moved up by nearly 80 per cent since then. 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 per cent-13 per cent 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 per cent. And therein lies the difficulty.

For a GDP that is expected to log in nominal growth rate in the region of 10-12 per cent, a 27 per cent 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.

Source: BSE

The BSE-Midcap Index has moved up by nearly 108 per cent 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 per cent 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.

Another concern that one could take into consideration is to look at the institutional activity. Looking at the table below, it clearly shows that FIIs have been dominating the show, pumping in more than Rs 30,000 crore (Rs 300 billion) in over thirteen weeks. On a relative basis, activity from the domestic mutual funds has been quite minimal.

Institutional activity over the past few months

(Rs bn)	FIIs	MFs
Mar-09	5	15
Apr-09	65	0.4
May-09	201	23
Jun-09*	34	-11
Total	306	27

Source: SEBI; *Till June 8 2009 for FIIs and June 5 2009 for MFs

It may be noted that during January and February this year, FIIs were net sellers, accounting for outflows worth Rs 4,200 crore (Rs 42 billion) and Rs 2,400 crore (Rs 24 billion) respectively. Thus, if they again turn their backs on India, the damage could be huge. Thus, unless earnings re-rate dramatically, fundamentals, at least in the medium term, point towards a correction of the magnitude of 20-25 per cent, which will again take us back to the fair valuation range.range.

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