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We are now neutral on India
November 10, 2010

Indian equity market is currently overvalued, we look at the reasons that have lead us to be neutral on India


Author : Manjunath Gaddi



Untitled Document

New Highs

The Indian equity market represented by SENSEX closed at an all-time high of 21,005 points on 5 November 2010 superseding the previous all-time high of 20,873 points as at 8 January 2008.  SENSEX has recovered well from the lows of 8,160 points as at 9 March 2009 post the global financial crisis and chaos on the Wall Street. In a period of less than one year and seven months, SENSEX has given over 157% returns and is one of the better performing equity markets in the world.

Table 1: Estimated Earnings and Valuations

Market Index as at % Change Since 2010 2009 5 year  PE  PE PE Earnings  Earnings Earnings
  08-Nov-10 31-Oct-10 Returns YTD Returns Bondd yield 2010 2011 2012 Growth Yr 10 (%) Growth Yr 11 (%) Growth Yr 12 (%)
USA 1223.25 3.4% 9.7% 23.5% 1.11 14.7 12.8 11.3 35.8 14.5 14.1
Europe (DJ Stoxx 600) 271.91 2.2% 7.1% 28.0% 1.54 12.1 10.5 9.4 32.3 15.4 12.3
Japan^ 9732.92 5.8% -7.7% 19.0% 0.33 17.0 15.2 12.4 63.5 12.3 22.5
MSCI Emerging Markets 1154.18 4.4% 16.6% 74.5% 5.0 14.2 12.2 10.9 37.0 16.8 12.2
MSCI World  326.57 3.4% 9.1% 31.5% 1.3 14.5 12.5 11.0 55.5 15.3 13.6
MSCI Asia ex Jap 575.98 5.4% 18.8% 68.3% 3.0 15.9 14.2 12.6 29.4 11.6 12.7
Singapore 3300.4 5.0% 13.9% 64.5% 0.83 16.2 14.8 13.5 19.7 9.8 9.7
Hong Kong 24964.37 8.1% 14.1% 52.0% 1.02 15.9 13.8 12.0 19.2 15.6 14.6
Taiwan 8430.58 1.7% 3.0% 78.3% 0.98 14.0 12.2 11.7 100.3 14.5 5.1
Korea 1942.41 3.2% 15.4% 49.7% 4.13 10.8 9.8 8.9 54.7 9.6 10.7
China (HSML100)* 7849.79 7.1% 12.4% 61.3% 3.14 15.2 13.1 11.3 21.2 15.7 16.1
Shanghai A (SHASHR) 3309.763 6.1% 1.0% 80.0% 3.14 17.9 14.8 12.7 13.3 20.8 16.4
China A (CSI 300) 3548.57 5.0% -0.8% 96.7% 3.14 19.6 16.1 13.6 7.0 21.9 18.1
Malaysia 1519.84 0.9% 19.4% 45.2% 3.41 16.5 14.8 13.7 19.0 11.4 8.5
Thailand 1049.79 6.6% 42.9% 63.2% 2.83 14.1 12.1 10.6 15.9 16.1 14.7
India^ 20852.38 4.1% 19.4% 81.0% 7.81 21.2 17.6 14.9 15.4 20.3 17.7
Indonesia 3699.263 1.8% 46.0% 87.0% 6.28 18.8 15.3 13.3 19.0 23.3 15.1
Russia# 1628.3 2.6% 12.7% 128.6% 6.87 8.3 7.0 6.3 50.5 18.3 10.8
Brazil 72657.3672 2.8% 5.9% 82.7% 12.47 13.1 10.6 9.3 30.3 23.9 13.9
Australia 4778.4 2.5% -1.9% 30.8% 5.15 13.8 12.1 11.2 - 13.8 8.1
Nasdaq 100 2188.94 3.0% 17.7% 53.5% - 17.8 15.5 13.6 58.1 14.9 14.4
Asian Tech** 145.07 3.5% 7.0% 74.9% - 14.6 13.9 12.6 57.0 5.4 10.6
Source: iFAST Compilations, Bloomberg
^Japan’s and India's financial year 2010 ends in March 2010; hence, its PE, EPS numbers are for fiscal years 2011, 2012 and 2013
* Mainland Companies - Hang Seng Mainland 100 Index is a market capitalization weight index that comprise both H-share companies and red-chip
stocks listed in main board of SEHK and including in HSCI index. The index is the benchmark of all China Mainland stock performance in Hong Kong
# Russia benchmark index - RTSI$ is denominated in USD. However, 5 years bond yields are based on RUB denomiated sorveriegn bonds as there are no USD denominated bonds.
We acknowledge and accept the difference based on the assumption that while USD denominated share prices are not trading at a premium or discount to RUB denominated
share prices (for the same company stock), there should be no significant difference in tracking Russia equity index in either RUB or USD
**Bloomberg Asia Pacific Technology Index


As seen in Table 1, the SENSEX is trading at a PE of 21.2X for FY2010-11. The long-term fair PE value for SENSEX has been close to 17X, this implies that at any point of time if SENSEX has a PE of above 17X, the index is overvalued and if it is below 17X, it is undervalued. There is no doubt that the Indian equity markets are currently overvalued than what the fundamentals say. Based on fair valuation, we expect SENSEX to cross 23,500 points by March 2013. Even though the Indian economy is expected to grow at 8% to 8.5% in the long term, it is overvalued on a medium-term basis. Also, the risk of correction in SENSEX in short to medium term has increased due to the recent rally.

Indian markets in unchartered territory

The key factors which are a cause of concern for Indian equity market are listed below:

  1. From the current market levels, it is clear that the markets have priced in the expectations of high growth and corporate earnings in the long term. In fact, as seen in Table 1, the expected PE for 2011-12 for SENSEX is 17.6X, which is closer to the long-term fair PE value of 17. Ideally, we should have seen SENSEX reaching the current levels in FY2011-12 but since it has already attained that level in FY2010-11, it clearly indicates that SENSEX is overvalued by one year.

  2. Since the 2008 crisis which wreaked havoc on the global financial system, the investor confidence in Indian equity market especially that of Foreign Institutional Investors (FIIs) has taken a complete ‘U’ turn, from being excessively bearish to excessively bullish. This is evident through the robust FII flows in 2010. In 2008, the FIIs withdrew close to US$12 billion; while in 2010, the FIIs have pumped in close to US$24.8 billion USD as at end of October. Out of this US$24.8 billion, around 48% (US$ 11.85 billion) has come in last two months. With such high inflows, the risk of FII flow reversal to Indian equity markets has increased. If any negative economic event were to occur, a repeat of heavy outflows as seen in 2008 may lead to a sharp Correction. 
  1. The negative effect of high inflows from FIIs is that it leads to Rupee appreciation, which decreases the attractiveness of Indian exports. Year to Date (YTD), the Rupee had appreciated by 4.5% against the US Dollar.Although the government does not wish to resort to capital control measures on inflows on FIIs at present, it has kept its options open to resort to capital control measures like those we have witnessed in Thailand, South Korea and Brazil. Capital control measures may lead to FIIs redeeming their investments from India, which can again lead to negative performance of SENSEX

  2. Currently in India, we have negative excess yields. Excess yield is calculated by subtracting the inverse of SENSEX PE with the yield of the 10 year or 5 Year Government Security or Bond (G- Sec). The same can be seen in Chart 1 which shows the SENSEX level along with the excess yields over 10 Year and 5 Year G–Secs since 2000. In the current situation, negative excess yield is due to both higher PE values and higher yields of G-Secs. It is well known that equities as an asset class is more risky than bonds. A positive excess yield implies that equities have more potential to give higher returns in comparison to the G-Secs while a negative excess yield implies that the G-Secs have more potential to give higher returns than equities. Investing in equities when you have a negative excess yield also implies that you may be taking higher risk but your returns may  be much lower or even negative.   

Chart 1: SENSEX LEVEL and Excess yields

Downgrading India to 2.5 Stars (Neutral)

After considering current valuations and earnings expectations, we think that the Indian equity market now looks overvalued on an absolute as well as relative basis, which warrants a downgrade. We are thus downgrading our star rating on the Indian equity market to 2.5 stars (“Neutral”) from 3.5 stars (“Attractive”).


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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