Indian markets, as reflected by iShares MSCI (BATS:INDA), are trading at rich valuations, which some Bulls like to call a temporary situation and earnings will eventually catch up, but the exuberance might be misplaced. The equity market performance, with major Indian indices up high single digits year-to-day and up almost 25-30% from the February lows, is impressive, especially for outside investors, given the relatively strong INR (Indian Rupee), but changing fundamentals suggest some amount of profit booking/ hedging might be warranted soon.
No doubt, Indian economy is expected to benefit from the government pay increases and improved rural economy over the coming quarters, as covered in my recent note, but the Street expectations, at least looking at the valuations, seem to be baking in much of the improvement.
Rich valuations
Right now, Sensex (local equity index) is trading around 18-20 times forward earnings, which is a significant premium to the MSCI emerging market index that is trading around 13-14 times forward earnings as well as the last ten year's average valuation of the Indian market. Indeed, almost one standard deviation above the 10-year mean.Over last five years, the index has traded around 15-16 times earnings and on a trailing basis, Sensex is currently trading at more than 20 times earnings.
Off course, the Bull-side argument is based upon the expectations of a strong recovery, improving the earnings side of the equation, and declining interest rates. Indeed, some Street analysts have started to compare Indian earnings yield to that of the 10-year U.S. bond to highlight the case for further expansion of the trading multiple.
Earnings at risk
A big problem for the Bull-side thesis is that the earnings are failing to live up to the promise. The result season is mostly over and there is a lot to be disappointed. The Street is expecting around mid-teens type of earnings growth, down from 17-18% type of earnings growth at the beginning of the year to almost 13-14% type of growth now. Interestingly, during this timeframe, interest rates have come down, good monsoon season has given a boost to the expectations of a stronger rural economy and government spending, including subsidies outgo, has increased significantly.
The economy is also starting to show its vulnerabilities, be it inflation, as covered in my earlier note or the GDP growth, highlighted by the latest numbers. The latest reading from the Ministry of Statistics and Programme Implementation of India reported that the Indian GDP grew 7.1% during April-June quarter, the lowest growth rate seen during the past five quarters, down from 7.9% in the quarter before and 7.5% in the same quarter last year. Pretty unimpressive showing, since the economists were expecting 7.4%, but besides the weaker than expected GDP growth, gross fixed capital formation contracted by 3.2% and private final consumption expenditure was up merely 6.7%. All in all, not the type of data that supports high earnings growth.
What the overly ambitious earnings growth expectations fail to fully acknowledge is that Indian corporate earnings are not that isolated from the global economic trends. After all, almost 40-45% of the earnings for the fifty Nifty constituents are linked to global sectors and the same is starting to bear on the results. For global investors, currency may offer another reason to turn cautious. Relative to some of the other emerging economies, INR has held up well, helping the returns in dollar terms, but with Fed tightening back on the table, the edge might get minimized going forward.
