Boom Year 2006: Is the party over for Equity in 2007?

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Boom Year 2006: Is the party over for Equity in 2007?

The year 2006 has been another great year for the Indian equity markets, with a gain of over 40% for the benchmark BSE Sensex. The Sensex breezed past several thousand-point levels; took out 10,000 with ease and even traded above 14,000 levels in December. This has beaten the expectations of most market experts. But while the Sensex may appear to be at all-time highs, we feel 2007 will present opportunities for equity investors.

Economic and corporate fundamentals are in good shape, which makes the case weak for calling the top of the market, or expecting a bear run. Let us not forget that India remains one of the fastest growing economies, driven by its favorable demographics, infrastructure spending and outsourcing. These trends are also driving investments by corporates into fixed asset creation. At the same time, both the Government and the RBI have been trying to address a possible overheating of the economy by pre-emptive measures. Corporate India’s earnings grew by over 25% in H1FY07, beating market expectations. Also, the experience of 2006 has shown that corporate earnings have beaten market expectations by a wide margin, leading to earnings upgrades by analysts. Given the strong evidence of consumer and corporate demand, we could have a similar situation in 2007 where analysts are forced to upgrade earnings mid-year.
But can the Indian market sustain current valuations?

We believe so. Indian equities are certainly not cheap at 16-17 times FY08 estimated earnings, but this can be justified by the expected corporate earnings growth of around 20% over FY06-08 E. While Indian valuations are higher than those of other emerging markets, we feel that an important reason for this is the composition of indices across markets. For example, in Brazil, “low P/E” or “commodity” sectors like metals & mining, oil & gas and financials constitute 55% of the index. We see that this is very similar for most emerging markets except India. In India, “high P/E” sectors like IT, telecom, FMCG and healthcare constitute around 40% of the Sensex; and the rest of the index is a balance of stock that would command “mid P/E” or “low P/E” valuations.

However, despite our overall bullish outlook, corrections can occur in 2007 from time to time as the market has demonstrated in the past. Key risks for 2007 from the international front are a global market meltdown and a sharp slowdown in the US economy. India-specific risks include political roadblocks due to state elections and higher than expected increase in domestic inflation and interest rates. However, the key drivers to any major bear run are weakening economic and corporate fundamentals, and we do not see any such signs on the ground. On the contrary, Corporate India is at its optimistic best due to the strong economy and demand trends.

In our final assessment, we feel that the markets still offer opportunities for investors in 2007, but these may be more stock-specific as the rally over the last six months has largely been restricted to a few index heavyweights. We advise investors to maintain equity exposure in 2007 and beyond, based on their individual risk-return threshold levels. As seen in 2006, exiting the market prematurely presents a risk for investors, as they may exit the market well below its potential. Over the long-term, a well-diversified and carefully picked portfolio of stocks either directly or through mutual funds can be expected to outperform other asset classes like bonds or bank deposits.
- Sanjay Sinha
The author is Head of Equities at SBI Mutual Fund.