This article appeared in the January, 2010 issue of Wealth Insight magazine.
The unpredictability of stock markets makes price trends impossible to predict. But certain long-term relationships hold, across time and across markets. As we enter a new year, it’s a good time to consider those relationships and their possible impact on 2010.
There is a direct relationship between earnings per share (EPS) growth and stock prices. When EPS grows, prices rise. But valuations, in terms of price-earnings ratios (P/E), also change even as EPS changes. Hence, while prices generally rise alongside EPS, the exact movement is unpredictable.
Valuation is a mean-reverting ratio. P/Es fluctuate, but eventually return to near average values. In the Indian markets, the average Nifty P/E is around 18. In the past six years, Nifty P/E ratios have moved between 10-29.
Stock prices anticipate future events. For example, the stock market crashed in January 2008, but EPS growth dropped only in July-September 2008. The stock market started recovering in April, 2009, but EPS growth accelerated only in July-September, 2009. The degree of anticipation is again, unpredictable.
There are other relationships with the broad economy. For example, EPS growth rises when gross domestic product (GDP) growth is high. P/E ratios fall when interest rates rise. Since interest rates are directly related to inflation, higher inflation triggers lower P/E ratios.
None of the relationships outlined above are linear and none holds 100 per cent of the time. Sometimes they conflict with each other. For example, in 2007, inflation rose, but so did P/E ratios and stock prices. That was because EPS growth was very high.
The ideal situation for a bull run is one of low inflation, coupled to high GDP growth. The worst situation tends to be one of stagflation - high inflation and low GDP growth.
The financial year (FY 2008-09) was marked by lower GDP growth and higher inflation as measured by the Wholesale Price Index (WPI). It was a classic bear market with over 55 per cent capital loss for index investors. Earlier, during 2004-08, fast EPS growth was associated with high GDP growth and low inflation The Nifty delivered over 300 per cent gains in those four years.
Although FH 2009-10 GDP growth (April-Sept, 2009) dropped versus FH 2008-09 (April-Sept, 2008), FH 2009-10 grew faster than second half 2008-09 (Sept, 2008-March, 2009). EPS growth between March, 2009 and September, 2009 reflected that recovery since it was good.
The market’s anticipation is that FY 2009-10 will see GDP and EPS growth that exceeds FY 2008-09, with a strong recovery in the second half. At the same time, investors hope inflation will remain moderate, although it is expected to rise beyond current levels.
The current P/E ratio is above 23 and that’s well above the historical average (18). The market has sustained higher P/E ratios only for a brief while, between August 2007-January 2008.
Can a P/E of 23 be sustained? According to valuation theory, the Nifty will need to see EPS growth at around 23 per cent, or more, to maintain a reasonable PEG (Price-earnings-growth) of 1 or less. Let’s say 25 per cent EPS growth for March, 2010 over March, 2009 would do the trick. In order to deliver that EPS growth, EPS will have to grow by about 15 per cent between September, 2009-March, 2010. To sustain 23 P/E till September, 2010, the Nifty EPS of September, 2010 would need to be up about 25 per cent over September, 2009.
We’ve marked those EPS projections though it’s wishful thinking, since we have no idea whether such EPS growth will actually occur. The September, 2009 GDP and WPI are preliminary estimates, subject to official revision. The EPS for September, 2009 is based on unaudited results for the past four quarters. The March, 2009 GDP and WPI are the current official projections.
What sort of GDP, or inflation, estimates would be required to be registered for an EPS growth that justifies current valuations of 23 P/E? Going by previous history, we’d need a combination of about 8 per cent GDP growth in 2010-11 coupled to a WPI below 7 per cent. The optimists would say this is likely, the pessimists would be doubtful. Either way, you have some broad benchmarks of what to look for. Happy New Year and fruitful investing!
This article was originally published on February 20, 2010.
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