The 3,500-point decline in the BSE Sensex from its November 2010 high of 21,000 has certainly made the Indian markets cheaper than they were just a few months ago.

The Sensex Price-Earnings (PE) multiple, which was perched at over 24.3 times in November, had tumbled to about 18.6 times by Monday. Purely from a numerical perspective, this market PE is not expensive for India. In fact, it is pretty close to the average valuation of 18.5 times that the Sensex has enjoyed (the high was 27 times and low at 11) over the past five years. The index is also trading at a forward PE (based on 2011-12 earnings) of 15, again not stiff from a historical perspective.

Does this make it a good time to buy stocks? Not necessarily, as the key worry for investors today is if the denominator in that PE — Earnings — will continue to grow. If it will, at what rate?

Numbers from Indian companies for the latest March quarter have revealed that while all is well with sales, profit growth is becoming much harder to come by. Rising raw material costs took the wind out of the sails of many large companies in sectors ranging from steel to real estate this quarter. Some of the earnings disappointments came from unexpected quarters too — a spike in “inflation related” costs for DLF, high one-offs for ONGC, a hit from employee provisioning for SBI and so on.

Now, even as companies are drawing up strategies to cope with the raw material pressures, another risk arises – the possibility of interest rates rising further.

With inflation remaining unabated, the RBI has indicated in its recent policy review that it is not done with its rate hikes yet. That is bad news for companies in sectors such as automobiles, banks, realty and infrastructure, where either demand or capital expansion plans hinge on interest rates. Low growth in macro indicators such as the Index of Industrial Production (it grew only 6.3 per cent in April) reinforces these apprehensions.

If fundamental risks have levelled one set of stocks, newly aggressive regulators and a range of exposes on scams have flagged governance concerns for others, beating down their valuations.

Downgrade cycle

The above risks have already prompted brokerages to revise their profit expectations for Indian companies downward over the past few quarters, calling into question the growth rates that can realistically be factored into the market PE. “The earnings growth of the Sensex companies in Q4FY2011 was significantly lower than expectations. During the quarter, the aggregate adjusted earnings of Sensex companies grew 2.4 per cent year-on-year compared with our expectation of a 20.3 per cent,” noted Sharekhan in its March 2011 quarter earnings review.

Looming risks and signs of slippage in earnings have in fact resulted in a 8 per cent reduction in the Sensex earnings estimate for 2011-12 to Rs 1,200 levels this year. Until this ‘downgrade cycle' comes to a halt and growth picks up, investors may find it difficult to summon up the conviction to make a significant bet on the stock markets.

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