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N Mahalakshmi / The Smart Investor | September 22, 2003

The Supreme Court's ruling on the privatisation of petroleum companies may have lowered the boom, but most market analysts were relieved to see the indices losing ground last week.

Reason: The spectre of a market soaring out of control was scaring the daylights out of everybody.

After a rapid-fire 1,500-point rise in the Sensex, the 300-point drop from the peak Sensex level has been welcomed as a healthy correction, something that will strengthen the long-term bull run in equities.

Most research houses are predicting a Sensex value upwards of 5,000 within the next 12 months. While Kotak Securities is forecasting a level of 4,900, CLSA is forecasting a more modest 4,800.

More bullish are Enam, Merrill Lynch and Salomon Smith Barney. While Enam and Merrill Lynch expect the market to pierce the 5,000 barrier, Salomon Smith Barney is talking of 5,300.

However, the near-term reality is a technical correction. How far down will the correction take the Sensex?

Last Friday, the index closed at 4134, and most participants, including the bullish brokers mentioned above, are expecting to plunge to continue - may be even below 4,000.

The most pessimistic forecasts take the Sensex down to 3,700. Nothing catastrophic.

The supporting arguments for dismissing last week's correction as a mere blip on the road to Sensex 5,000 remain pretty much the same as before.

The macro-economic picture is looking good, with GDP growth set to recover on the back of good rainfall. Infrastructure spending is likely to keep demand for commodities like cement and steel buoyant.

So is the boom in consumer credit which will hold up demand for consumer durables and automobiles.

Then, the outsourcing story continues to reverberate, pushing up prospects for companies in the IT and IT-enabled services space, as well as auto and auto ancillaries, pharma and textiles.

The picture on the corporate side, too, is bright. Many corporates have restructured themselves thoroughly to become competitive on a global basis.

India Inc's return on equity has improved significantly over the last couple of years.

The EVA (economic value added, which calculate profits after adjusting for cost of capital) of India Inc has turned positive for the first time in the history.

Analysts say there is reason to believe that these companies will be able to perform significantly better in the coming quarters as the economic climate is likely to improve further.

Also, many listed companies have achieved record high profits while their market-cap is still below their historic highs. The Sensex currently trades at 15 times earnings on a trailing basis and 12.8 times on a one-year forward basis.

In contrast, the current yield on risk-free debt translates into a price-multiple of 18. This, analysts feel, leaves enough scope for further appreciation.

More importantly, this time around there is ample liquidity in the system to support equities.

While foreign institutional investors have already poured in over Rs 13,000 crore (Rs 130 billion) this year, domestic mutual funds have been witnessing positive flows in the last two months.

So domestic mutual funds, too, have been net buyers in the markets during the period.

The Smart Investor spoke to experts to get a feel for how the market looks from three levels: the macro or economy level, the micro or corporate level, and the technical level.

Subir Gokarn, chief economist at the country's top debt-rating agency Crisil, is bullish on the economy. "I expect the economy to grow by around 6.5 to 7 per cent for this fiscal. The two drivers for this are housing and roads, basically construction-related sectors" he says.

However, Gokarn is quick to point out that the current stock markets do not fully reflect the growth in the economy over the last decade.

"The main reason here is that the sectors that have grown are not a part of the markets, except IT and automobiles. Service sectors like entertainment and security (agencies) have grown tremendously but there has not been enough representation until recently. The dynamics of the growing sectors are not reflected in the markets."

Falling interest rates will also impact positively on the corporate sector, he says.

Jyotivardan Jaipuria, head of research, DSP Merrill Lynch, lives up to his organisation's baseline: "Be bullish." Given today's operating conditions, his prognosis is that the Sensex will touch 5,000 over the next one year.

"We forecast an earnings growth of 17 per cent for FY04 and 15 per cent for FY05. Though we do not expect any significant re-rating over the next year from current levels, our earnings growth projections drive our index target of 5,000," he explains.

Ajay Bhatia, head of research at Enam, says the current rally is different from rallies in the last decade because it is the result of a structural change in the corporate sector.

"Since we are primarily betting on structural shifts in the economy, our favourite sector picks are automobiles and auto ancillaries, cement, banks and media - all of which are seeing structural changes."

He thinks valuations in the technology sector still look stretched.

Our technical analyst says that it isn't over-optimistic to expect the markets to move up till a peak of 5300-5500 Sensex and for the bull run to last till around July 2004.

However, a possible dip to 3700 is on cards based on a 50 per cent retracement of the recent upmove.

What will drive the Sensex up

India Inc has become EVA positive; stage set for secular bull run.

P/E multiple for debt is around 18x while that for equities is 12x one-year forward earnings.

Structural shifts in industries like automobiles, cement, banking and media mean further upside for stocks.

Technical indicators suggest a peak of 5300-5500 by July 2004.

What will drag it down

Fibonacci retracement of 50 per cent means a possible dip to around 3700.

Risk of political upheavals.

'Sensex will touch 5,000 within next one year'

Jyotivardhan Jaipuria is a management graduate from Indian Institute of Management, Ahmedabad. He has been with DSP Merrill Lynch for the last nine years. Prior to this he was with ICICI. He is quite bullish about the market.

On market outlook

After a sharp rally, the markets are likely to go through a phase of consolidation and correction. Over the past couple of weeks, we have already seen the markets starting to correct.

This is only a pause and the markets are looking at high levels on the Sensex over the next year. Our one-year target for the Sensex is 5000, after the formation of the new government.

Fundamentally, we are likely to see an improvement in the economy as well as better flows to the markets.

In terms of the economy, we expect agriculture growth to be strong following the good monsoons. This should drive GDP growth to 6.4 per cent for FY04.

On liquidity scenario

We believe domestic liquidity to the equity markets will be strong. Two important changes should likely be positive for domestic flows to equity markets:

Firstly, the UTI problem is behind us. Worries on UTI selling had been a constant drag on the markets over the past few years. With the UTI problem being over (by issue of tax-free bonds), the market is not worried about forced selling by any institutional player.

Secondly, bond markets are peaking out. After a sharp rally in the bond markets over the past two-three years, capital appreciation in bonds is likely to be limited.

Hence, for investors, returns in the bond market may reflect interest rates. Given that interest rates have fallen, we believe retail money on the margin will move to equity.

Remember that portfolios of investors have become totally risk averse with equities accounting for just 2-4 per cent of total savings versus over 10 per cent a decade ago.

FIIs continue to be positive on India. Our interaction with them indicate that India has been recognised as one of the fastest growing economies in the world.

Given the record inflows this year and the fact that India is one of the biggest overweight markets for FIIs in the GEM universe, we see weightage to India likely to be constant.

However, with emerging markets continuing to be the flavor, a shift in allocation from the developed to emerging markets should help India, too.

On corporate earnings and stock valuations

The fundamental scenario continues to be attractive on the back of good monsoons. This, we believe, could lead to a recovery in the economy starting December 2003 and help sustain a trend of earnings revision.

After a spell of earnings downgrades, earnings are again being marked up as the global economy performs better than expected and expectations of a bounce in the domestic economy are factored into earnings.

At a bottom up level, we forecast earnings growth of 17 per cent for FY04 and 15 per cent for FY05.

While the index has got re-rated over the past few months, it continues to be well below historic averages. We do not expect any significant re-rating over the next year from the current levels.

However, earnings growth of over 15 per cent drives our index target of 5000 over one year at a PE of 12.8x one-year forward, similar to the levels currently.

On sectors that are likely to outperform

We expect most sectors do to well going forward on the back of a general pick-up in the economy. Specific stock stories will be more in demand.

Overall, however, we would be bullish on sectors that benefit from the improvement in the economy. I would favor heavy commercial vehicles segment that would benefit from the highway project.

We believe the shift from rail to road traffic would get accelerated due to the highway projects that would boost the demand for trucks.

Within the auto sector, we see a gradual improvement in the health of the tractor segment due to good monsoons.

However, this may not be reflected in sales immediately since the inventory in the system was running at high levels. I would also favor infrastructure plays especially in the power equipment space.

With the passage of the Electricity Bill we expect an improvement in the health of the state electricity boards.

This coupled with the increased thrust on generation by the state-owned utility companies will lead to a sustained demand for power generating equipment companies.

Banking is another sector I continue to be bullish on given the likely structural changes in the lending profile as well as improvement in non-performing loans.

Banks are successfully shifting their loan profile towards retail credit that has higher margin.

NPLs are likely to fall given the recovery in the economy, especially in sectors like steel. Foreclosure norms will provide a further boost to the banks in recovering their dues.

On how news flows will impact markets

Markets always react to events in the near term but focuses back on fundamentals as the initial surprise or shock wears off.

Over the past few weeks we have seen some examples in the form of the tragic bomb blasts in Mumbai or the shock over the Supreme Court judgment on the privatisation of oil companies.

After the initial disappointment, markets recovered quickly.

In the near term, we believe corporate results next month will be a significant driver for the markets.

Politics is another event the markets may focus on near term, especially with five Assembly elections likely over next few weeks.

On risks associated with markets in election years

Historically, election years (2004 will be one) have been good for the markets with economic reforms moving smoother in the absence of electoral considerations.

This partly reflects the fact that irrespective of the nature and shape of the government, reforms are accelerated as electoral considerations evaporate.

Typically, the first two to three years of the five-year tenure of the government will see maximum reforms.

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