>Pause, Rewind, Replay (MORGAN STANLEY)

■ Key Debate: Are Indian equities set up for a significant correction?
The market is up 100% since its low in March 2009, and is now up 92% over the trailing 12-months. Reported earnings growth is still tepid and reforms are moving slower than expected by certain quarters. The central bank has been sending signals on a possible exit policy and at the same time equity supply is burgeoning. Crude oil prices are threatening to move higher with negative consequences on India’s macro whereas relative valuations do not seem attractive anymore. India is among the top 5 performing markets globally this year, and it would seem a lot of the good news and more is in the price. Does all of this mean that Indian equities are set for a significant correction?

■ Indian equities in a sweet spot, but…
We reckon that Indian equities are in a sweet spot with low institutional ownership (coming off five-year lows), strong liquidity (policy makers are still reticent to take away stimulus), prospects of growth (watch out for private corporate capex – the trough is likely behind us), earnings upgrade (indeed, we are at the start of earnings growth cycle), strong corporate balance sheets, and stable politics (implying steady pace of reforms).

■ …the pace of gains is likely to slow
Our Dec-2010 target for the Sensex (19,400) suggests upside of 19%, reflecting a slower pace of gains after a stellar performance over the past six months. Our prognosis is that Indian equities could be volatile in the near term, since a lot of the next six months’ projected growth is already
in the price. We believe that investors should use such volatility to buy Indian shares, since the growth outlook for the next 12-18 months remains firm and is still not priced into equities. Heightened volatility could make trading a less-rewarding strategy compared to “buy on dips and hold”. Our bull-case scenario takes the Sensex well past its previous high, whereas our bear case could lead it to test the post-election result close of May 18.

■ Key factors to watch
Key factors that could determine market behavior include government policies (watch out for infrastructure spending), global markets (correlation with SPX and China is still high), crude oil prices (a sharp spike creates problems, the risks are lower if a crude oil price rise is accompanied by strong capital flows), long bond yields (reflecting fiscal position), the RBI’s exit policy (and hence liquidity), sentiment indicators (watch market breadth and momentum, which suggests weak share prices in the offing), equity supply (the market may not tolerate more than US$20-25bn in the coming year), and valuations (relative valuations have moved above average levels).

■ Portfolio position: Continue to prefer cyclicals over defensives
We believe that consumer and infrastructure sectors will drive growth recovery and, hence, market performance. Accordingly, we are overweight Consumer Discretionary, Industrials, Financials, and Energy in our model portfolio. We expect the broad market to outperform the narrow market.

Key Investment Debates

• Macro forecasts: Politics are in good shape, and that should allow a reasonable policy momentum. The government is already moving forward with significant tax reforms, and our belief is that infrastructure spending should pick up pace in the coming 12 months, especially in electricity and roads. We are forecasting GDP growth of 6.4% and 8% in F2010 and F2011, respectively, ahead of the consensus. More important, for the market, industrial growth is likely to accelerate over the coming 12 months. Acceleration in industrial growth will likely close the output gap faster than current expectations. The supply-side factors, including the availability of capital and its cost, favor a trough in capex and a recovery in the coming 12 months. We don’t believe this is still in the price.

• Earnings growth: We have been raising our earnings growth forecasts just like the bottom-up consensus. We are now looking for 15% and 23% growth for the BSE Sensex constituents on aggregate in F2010 and F2011, respectively, compared with 5% and 20% by the consensus.
Revenue growth seems to have bottomed out given our view that industrial growth is likely to recover sharply in the coming months. The strength of the recovery could bear upside depending on execution of policy reforms. The corporate sector seems to have cut costs and thus margins have improved sharply. The macro environment (i.e., higher consumer price inflation vs. wholesale price inflation after adjusting for food prices) favors a robust rebound in margins in the coming four quarters. We think these three factors have set us up for strong earnings growth over the next 12 months. It is quite likely that broad market earnings growth will accelerate faster than the narrow market, as we saw in the previous cycle. We expect broad market earnings growth to average 20% and 25% in F2010 and F2011, respectively

• Valuations: The market’s valuations do not appear attractive to us, although they are also not stretched. The prospects of earnings upgrades means that valuations could turn out to be attractive in hindsight. On our estimates, the Sensex is trading at 16.3x and 13x F2010 and F2011 earnings, respectively. The 12-month forward P/E for the MSCI Index is at a 29% premium to the emerging market multiple, making India the fourth-most expensive EM. At a 10-year bond yield of 7.4%, investors are realizing a risk premium of 6.4%, which suggests that the market is attractive for long-term returns. At the same time, the absolute P/E and P/B are 95% and 73%, respectively, off their all-time lows.

• Ownership, cash levels, equity supply and liquidity: FII ownership is coming off a 5½ year low and is well off the peak. Mutual cash balances have reduced over the past three months, but still have substantial cash in their portfolios. In the meanwhile, the rising equity supply could cause
a problem for the market if it gets bunched up, as we saw recently. Excess liquidity in the system could be more than US$32 billion. Market behavior in the previous two tightening cycles has been mixed, and hence is inconclusive.

• Sentiment: The market can no longer rely on depressed sentiment as a guide to better returns, in our view. Sentiment has turned up sharply over the past three months, and our market timing indicator is no longer in a buy zone. Some components of our proprietary composite sentiment indicator, notably, momentum metrics and volatility measures, suggest that the market could sell off. We think market participants should keep eye on breadth and trading turnover.

To see the full report: INDIA STRATEGY