Fundamentals alone prevail

Equity prices are determined by demand and supply, just like in any other market. If demand for a stock is more than its supply, its price moves up. Demand for the stock comes from availability of liquidity (or money). In the short term, therefore, stock price is more a function of liquidity than valuations. Years ago, a client summed it up very well: “Don’t try to fight liquidity.”

Valuations, on the other hand, serve as a tool to understand whether the price of the stock justifies the ability of its underlying business to provide expected returns. Hence, valuations are governed by two variables: the ability to predict future income generation, and to understand what the expected return is.

Liquidity has taken the central role in determining how the markets should trade in the recent past as governments all over have been pumping trillions to stimulate their economies hoping that the money cover provided will help them come out of trouble. It has caused imbalances elsewhere.

Liquidity has chased risk assets such as commodities, equities and high-yield bonds. It has caused turmoil in the currency markets and inflation in many emerging markets, the effects of which are beginning to be felt in our country.

Different impact

At various stages liquidity has had a different impact. In the end, however, fundamentals have prevailed. It is just a matter of time.

For example, from February to July in 2007 and then from September to October in the same year, when we saw $10-billion and $9-billion worth of FII inflows, the Sensex went up 10 per cent and 30 per cent respectively, even as earnings growth was downgraded by 5 per cent and a further by 1 per cent during that time. Earnings began declining year-on-year during that period. As a result, there was an expansion of price-earning ratios by about 800 basis points.

All of this corrected subsequently between July 2008 and February 2009 as reported FII outflows touched $8 billion and the Sensex tanked 34 per cent. Most of the expansion in price-earning ratios was erased.

In the recent past from February 2009 to December 2010, FIIs invested $48 billion; the Sensex rose by 131 per cent and was also followed by a sharp 30 per cent growth in earnings. Price-earning ratios expanded by 775 basis points. From December 2010 to December 2011, FIIs were net sellers to the tune of a mere $512 million, but the market fell by 25 per cent, PE ratios fell by 565 basis points and earnings growth dropped from 30 per cent to 10 per cent (earnings were downgraded by 9 per cent through the year). From December 2011 to July, FIIs have invested $10 billion, the Sensex has moved up 12 per cent but PE ratios have expanded by a mere 74 basis points, following the 565 basis-point fall in the previous year. This is because earnings growth continued to fall.

In for Hard times

What this tells us is that one, when earnings growth is robust and coupled with liquidity, PE ratios expand rapidly. This happened in February 2009-December 2010. This was the best scenario for the markets. Two, when growth in earnings tapers off, the market also falls even if outflows are not strong. At almost negligible outflows, the Sensex fell by 25 per cent from December 2010 to December 2011.

Also, despite strong inflows in December-July, PE ratios expanded marginally, or the Sensex moved up just about 12 per cent as earnings continued to get downgraded.

We expect the downgrade in earnings to continue and should the flows dry up (I am not even suggesting outflows here), the fall in the Sensex could be sharp.

It is global liquidity which has held up the market so far, and I am not able to take a bet on whether it will continue or stop. The moment it does and if the earnings don’t begin recovering, we might be in for hard times.

(The author is Business Head, Institutional Equities, Emkay Global Financial Services Ltd. The views are personal.)

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