Why 2017 is not 2007

This year has all the ingredients of earnings recovery

My interactions with market participants — investors, advisors, distributors and analysts — indicate that there is comparison being done, consciously or unconsciously, of the current market condition to that of the market condition in 2007.

The participants are quick to point out that “the large cap index (Nifty) at 9600+ is trading at the Price to Earnings ratio (PER) of 22.5 on a trailing basis. In 2007 also, the PER was at 22.5 with Nifty at 6100+ levels and we know what happened in 2008”. While the data is factually correct, the inference is way off.

Then and now

The Price to Earning has two components — Price in the numerator and Earnings in the denominator. As indicated by Bloomberg, the earnings growth in December ’07 was 20.4 per cent on a trailing year basis and 28 per cent per annum on a trailing two-year basis.

The denominator (Earnings) was at an elevated level due to good earnings growth. Economic conditions were looking bright as shown in some data points like the IIP, which was clocking 15 per cent-plus year-on-year growth, the eight core industries which printed a growth of 6.4 per cent (one-year average) and credit growth (non-food) at 27 per cent. The RoE of the Nifty companies was at 29 per cent.

Contrast this with today. The earnings growth is 4.6 per cent on a trailing year basis and 5.8 per cent per annum on a trailing two-year basis. The IIP clocked a tepid single digit growth, the eight core industries printed a growth of 4.2 per cent (one-year average) and credit growth (non-food) at 5.1 per cent — lowest in over 60 years. The RoE of the Nifty companies is at 13.6 per cent. Today’s data points are sub-par in contrast to 2007 and also to long term averages. As the economy turns, the earnings will rebound to bring down the PER (as denominator will increase).

Price to Earnings is just one indicator. If one were to consider the Price to Book ratio, it is currently at 2.86x which is half of what it was in 2007 at 5.74x. The Price to Sales ratio is at 2.5x which is 30 per cent lower than 3.6x in 2007. The current dividend yield of the Nifty companies is at 1.58 per cent, which is about 56 per cent more than that in 2007 at 1 per cent.

The widely used indicator, which is Market capitalisation to GDP, is currently at 0.8x compared to 1.3x in 2017 (lower by 38 per cent). The Yield Gap Ratio, which is derived from the benchmark 10 year government security yield and market earnings yield, is at 1.5x compared to 1.75x in December ’07.

In December ’07, the one-, three-, five- and seven-year compounded returns of Nifty Index were 55 per cent, 43 per cent, 41 per cent and 25 per cent respectively. In comparison, the May’17 numbers are muted at 18, 10, 14 and 7 per cent. Hence, looking beyond the most widely used metric of PER, the other market centric metrics are below long-term averages and much below the euphoric period of 2007.

The ten-year average of Nifty RoE is at 16.6 per cent. Remember that the last ten years mostly constitute the post global financial crises period. Even if the current RoE were to pull back from the current level of 13.6 per cent to half the distance of the ten year average to reach 15.1 per cent over the next five years, the implied growth in earnings for the next five years is 14 per cent per annum. This earnings growth can be achieved with a reasonable degree of probability.

More to go from here

It is a fact that earnings growth has been elusive for the last three years. However, this year has all the ingredients of earnings recovery. Global growth is looking up. In such a scenario, India does well as exports grow. On the consumption side, normal monsoon leading to good crop production, rural economic revival, lower interest rates and Seventh Pay Commission payouts by States and PSUs could help.

On the investment side, interest rate transmission to corporates and increased government capital expenditure could help in uptick of earnings. Even if one were to assume a higher teen earnings growth for the next three years and derating in PER from current levels, markets can still deliver a decent double-digit return.

Equities, by their very nature, move ahead of improvement in the real economy, which is exactly what is happening today. We are not in a euphoric or bubble zone. Clearly 2017 is not 2007. There is more to go from here. Keep focus on your goals!

The writer is Co-Chief Investment Officer, Birla Sun Life Asset Management Company

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