The global euphoria over a EU debt deal led to an explosive 5% rally in Indian equities. Yet I believe that the Sensex is a short at 17000-17400. The blood, sweat and tears short trade on Dalal Street that I recommended since late 2010 (when Sensex above 21000 and I called for a 15000 target) will soon resume with a vengeance. The short on ICICI ADR in New York has proved the ultimate trade in the past eleven months! So what is the bearish case for Sensex in the next three months?
One, Sensex cannot rally until wholesale inflation peaks and the RBI pauses in its tightening cycle. This is not imminent even though the monetary squeeze has dampened bank loan demand and industrial production. If food prices fall on a good monsoon, if Brent declines by another $10, it is entirely possible that the RBI will signal a pause in its tightening cycle. Yet this can only happen in December at the earliest. India has the highest wholesale price inflation among the BRIC states for now. A RBI pause is necessary but not sufficient to awaken the bulls on Sensex. A RBI rate cut is needed – and that is a spring/summer 2012 story!.
Two, earnings growth in India will continue to disappoint, as Reliance and Tata (NYSE:TCS) demonstrated. The most draconian RBI monetary tightening in modern time during a time of slowing growth will take its toll on EPS growth. In fact, the stock market has yet to price in a slowdown in EPS and economic growth. After all, India’s growth is dominated by investment and capex, an incredible 40% of GDP.
Three, political risk in India is rising after the 2G telecom spectrum corruption scandal, the Commonwealth Games debacle, the mysterious illness of Sonia Gandhi and the Anna Hazare anti-corruption movement. This will hit both FDI flows and capex, to the detriment industrial growth.
Four, notice that even the risk on trade in FX has not really boosted the Indian rupee, still at 49 to the dollar. While Goldman Sachs predicted a 44 target for the rupee in the past six months, I argued exactly the opposite. After all, a 10% inflation rate and a current account deficit financed by hot money flows in to Dalal Street is the kiss of death for the rupee. The rupee can well fall below its post-Lehman low of 51 to the dollar. This will mean more outflows from Dalal Street and a lower Sensex.
Five, India trades at 14 times forward earnings. This makes it extremely expensive among the major emerging markets and a 40% premium to MSCI EM index is not justified at a time of slowing growth, higher secular inflation and capital flight. The Sensex historically bottoms at 10 times forward earnings after a cyclical bear market. I can easily see the Sensex at 14000 by early 2012. Nifty is a short at 5200 for a 4500 target. The Indian property crash is still in its early stages, as I have long argued. When the music stops you sell not what you must, you sell what you can! This is a lesson the world learn the hard way in the leveraged, illiquid real estate market.