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Downside Risks Higher

There is a greater possibility of the markets declining rather than moving up in the near future

The stock market has seen an extraordinary bull-run since late 2008. After hitting a low of Nifty 2,253 in October 2008, it rebounded to above 6,300 in November 2010. Even after the recent correction, it is trading at 5,975 (December 7). That’s 14 per cent up since January 2010 and 97 per cent up since January 2009.

Will this positive trend continue through 2011? Historic performance doesn’t imply positive future trends. In fact, it makes big gains less likely. Every economy has a boom-bust cycle. The longer a boom lasts, the more likely that a major bust is just around the corner. The higher the prevailing valuations, the more the potential downside.

Let’s list some reasons why the stock market may trend up. And then, we shall list reasons why it might trend down.

The last big bull run lasted 44 months between June 2004 (Nifty 1,500) and January 2008 (peak of 6,357). This bull market has lasted between 21-27 months, depending on the interpretation of the period between October 2008 and March 2009 when the market range traded 2,500-2,600 levels. So there’s potential upside in terms of macro-economic cycle time.

Indian macro-economic projections for 2011 are positive. Growth should accelerate. The statistical data is backed by business confidence. Turnover and earnings growth in turn could trigger moves further north.

The global economic recovery continues though it’s not very strong. So there isn’t too much worry on the external front. On the policy and political front, while the government has been hit by repeated scams, it appears firmly in the saddle. Reforms do continue — albeit at slower pace than one would like.

So much for the positives. But when you look at the details, doubts start arising. First, the length of the boom of 2004-2008 was an aberration driven by surplus cash flows. The 2009-2010 expansion doesn’t have that in its favour. It could be on the verge of flattening. If momentum is lost, a primary cause would be rising interest rates. Inflation has been high for a while, and looks unlikely to abate. Interest rates have risen through 2010 and are still rising. We’ve seen a negative impact: FH 2010-11 corporate results showed lower net profit margins due to rising interest costs. So far, turnover growth has been good enough.

But if rates continue to rise, turnover in rate-sensitive sectors like housing finance, automobile and of course, banking, could be impacted. Infrastructure project financing may get tighter as well. And without investments in infrastructure, there would be a bottleneck hindering future growth.

In terms of valuations, it is difficult to justify current PE discounts on fundamental grounds. The Nifty’s weighted average PE ratio is at 24, the PBV is high at 3.76, and the dividend yield is low at about 1 per cent. These levels are usually not sustained for very long periods — the Nifty’s average 10-year PE is 17-18.

In order to justify these valuations in comparison with risk-free returns, we would need interest rates ranging at a maximum of around 5 per cent. As of now, T-Bills are being auctioned in the 6.9 per cent range and commercial rates are obviously higher. So current equity valuations cannot be justified on the basis of risk-free returns.

Can they be justified by anticipated earning growth? In order to justify 24 PE we would need EPS growth of around 24 per cent to maintain an acceptable PEG ratio of 1.

Over the past four quarters, the Nifty’s EPS has grown by around 11 per cent. It’s difficult to imagine EPS growth accelerating that much in SH 2010-11 and FH 2011-2012. If EPS growth through the next six months is lower than 24 per cent, disappointed punters may sell the market down.

On the global front, there has been persistent currency weakness and fears of government default in the Euro region. Those dangers may make foreign institutional investors (FIIs) jittery. In 2010 (until December 7) the FIIs contributed Rs63,771 crore in net buying while the domestic institutions sold a net Rs22,728 crore. Clearly if FII attitude changes for the worse, there will be a negative impact.

So, one can make a logical case for the market swinging either way. Personally I’m rather bearish and think the probability of decline is higher. Of course, I could be very wrong. The potential for a decline is no reason to give up buying equity. But look for a greater margin of safety in terms of valuations, if you are buying specific stocks. If you are a passive index investor, be mentally prepared to maintain allocation through a decline.