Sell the rally, expect to see tough markets for another six months

Updated: Dec 31 2011, 06:34am hrs
Bank of America Merrill Lynch

India has been the worst-performing market this year, falling a third in dollar terms. Peaking inflation and the consequent pause in interest rate hikes are positives that will likely help the traditional December rally. However, we continue to expect a tough market over the next six months and expect a correction of the Sensex to 14,500 points as growth concerns take centrestage.

GDP growth to slow; downgrades likely

We expect FY13 GDP to slow to 6.8% and consensus to cut GDP forecasts over the next few months. GDP growth in the next few quarters is likely to come even lower at around 6.5%. A slower GDP will be led by: (a) a slowing global economy, (b) impact of high rates and (c) slowing investment spend.

We continue to expect earnings downgrades, led by slowing sales and sustained margin

pressure from rising labour and interest costs. We expect the

bottom-up Sensex EPS of R1,275 to be downgraded to R1,200 (growth of under 10% vs expectations of nearly 15%).

Valuations to see slight de-rating

Based on analysts forecasts, markets at 13X one-year forward PE are at a slight discount to long-term averages. Slowdown in GDP and earnings growth as well as falling RoEs will likely lead markets to trade lower. Secondly, on a relative basis, India trades at a 27% PE premium to gloal emerging markets (GEM), higher than a 10-year average of 17%.

Markets stop panicking when policymakers start panicking; year-end index 19,000

The good news is that we could get some positive returns in 2012 if policymakers take steps to reverse the economic slowdown like (a) aggressive rate cuts by RBI we expect rate cuts from April 2012 (though slow given sticky inflation); markets typically rally 3-6 months after the rate-cut cycle starts, and (b) policy reforms by the government.

Markets likely to see a further correction to 14,500

In spite of the sharp fall in markets, we still do not recommend buying the markets. We expect further weakness to 14,500 points over the next six months, led by disappointment in growth, both in GDP as well as earnings.

Sell the year-end rally

December has historically been a positive month for the Indian markets with a negative return only once in the past 20 years (and two years of less than 1% negative returns). We could see a year-end rally this year too given a likely pause in RBI rate hikes. However, we would advise investors to sell the year-end rally.

Easing inflation, likely rate pause a positive...

The biggest worry for the market this year has been rising inflation and consequent rate hikes. The good news is that inflation has peaked and we believe the rate hikes are now behind us. We expect the market focus to shift to RBIs rate-cut cycle which we expect to commence from April 2012.

...but growth concerns will take centre stage

We expect growth concerns will become the focus of the market. The correction in the market will be led by four factors.

From inflation to growth concerns: We expect the market to shift focus to growth concerns, with GDP growth likely to slow below 7% in FY13. We expect a growth of 6.8%. We believe GDP forecasts will see downgrades due to (a) a slowing global economy, (b) the impact of rising rates and (c) pressure on economic growth due to slowing investment.

Earnings downgrades to continue: Our expectation through 2011 was that earnings will get downgraded signifintly. We continue to expect earnings to get downgraded in 2012. We believe FY13 earnings growth will be under 10% compared to the current expectations of close to 15%.

Valuations will see slight de-rating: The market currently trades at 13X one-year forward earnings below the long-term average of 14.2X. However, earnings are seeing downgrades and, hence, PEs may be higher than currently believed based on existing analyst forecasts. Secondly, given the slowing GDP and earnings growth, we believe the market should trade at a discount to the historical average. Similarly, while the India market trades at a P/B of 2.3X, an 18% discount to the historical average, lower RoEs than history justify this de-rating.

No capitulation on India: Overall, funds had turned underweight on India in the early part of the year. But latest data show that India is again an overweight market, though slight, for GEM funds. Compared to the $28-billion FII inflows last year, we have seen only marginal outflows this year.

Rate cuts to help positive year-end index move to 19,000

We believe an aggressive rate cut by the RBI will help the market in late 2012. While the past history of rate cuts in India is limited with only two rate-cut cycles over the past 20 years, there are three conclusions we can draw:

(1) During both previous two rate cuts, the market bottomed out 3-6 months after the first rate cut.

(2) History shows the market rallies sharply after a few rate cuts. However, buying the first rate cut has not made money for investors. Two, the sustainability of the rally is driven by the subsequent performance of the economy.

(3) On both previous rate cycles, the market re-rated as rates were cut and traded at PE multiples higher than long-term averages.