Quick Comment – Earnings will determine market
behavior: Since the end of the previous bull market in
early 2008, the market’s direction has been determined
largely by the change in its multiple. This is not
surprising given that the starting point of valuations at
the end of 2007, when the market was trading at over
30x trailing earnings, suggest that growth expectations
were overly optimistic. Over the past five years, these
growth expectations have arguably moderated into fair
territory (implied equity risk premium is around 7%
versus 4% in Dec-07) and, hence, the key call for stock
returns going forward is what happens to earnings.
Over the medium term, as the earnings recovery gains
traction, growth expectations will rise and a multiple
increase will follow.
Market de-rated: Since 2008, the market multiple has
more than halved, causing the market to be down 14%
from the end of Dec-07 even though earnings have
nearly doubled – up 85% (Exhibit 2). The period
between 2003 and 2008 was much more rewarding for
both multiples and returns – the multiple nearly tripled
and earnings were up 2.5x, leading to a near seven-fold
rise in the index (Exhibit 3). Over 20 years, the market
has de-rated, highlighting the high expectations that
were embedded in stock prices two decades ago. At the
same time, the multiple has fallen 60% but earnings
have grown 10-fold, implying that the MSCI Index is up
over 4x (Exhibit 4).
Earnings expectations low: If its performance is an
indication, the market is dismissing the prospects of an
earnings recovery. Its 12-month trailing returns lead the
consensus 12-month forward EPS growth forecast by
six months. As seen in Exhibit 5, the returns on the
index suggest that the earnings growth could be close to
0% in the coming 12 months. In contrast, we believe
that a new earnings cycle is taking shape. Our earnings
growth-leading indicator suggests that the worst for
earnings growth is over (Exhibit 6). In the past five years,
falling gross margins and rising interest rates were prime
reasons for compressed earnings growth. Both appear
to be reversing. From a top-down angle, a collapse in
the investment rate and the widening current account deficit
explains the fall in the share of profits in GDP. While the
investment rate is stabilizing and recovering from its low point,
the CAD may have seen its worst in the Dec-12 quarter (given
fiscal consolidation and an INR that is no longer undervalued).
We believe that the earnings growth could rise to 15-20% by
the end of the next 12 months.
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