How low can the Sensex go?

After waiting with bated breath for just this announcement for much of the year, the stock market greeted the RBI's decision to halt its rate-hike cycle with supreme indifference last week. In fact, the Sensex's 400-point plunge after this event suggests that we may well be approaching the last and most painful leg of the ongoing bear phase.

Price action in asset classes across the world is also reminiscent of 2008. With the global slowdown a certainty, stock market is giving up gains, commodity prices are taking it on the chin and oil prices are cooling off. Why, even gold — the ultimate investor haven in the past year — is now in full retreat, having plunged nearly 20 per cent, accompanied by dark murmurs about a bear market.

8000 again?

So, if Indian stocks see a further sell-off, how low can the Sensex go? Can it nosedive to its October 2008 nadir of 7,700 points? Though a panic selloff, by its very definition, may not be rational, we would like to stick our neck out and say that a Sensex low below 13,000 appears highly unlikely. Some simple maths explains why.

To assess how much lower markets can go, it is better to take stock of valuations rather than absolute index levels. The first point to note is that profits of Sensex companies in the first half of 2011-12 were a good 30 per cent higher than they were in the similar period of 2008. Earnings of the broader market (BSE 500 companies) are at least 20 per cent higher. Therefore, even if valuation multiples were to plunge to their October 2008 lows, the index is likely to bottom out at a much higher level.

History suggests that Indian stock markets have usually bottomed out whenever the Sensex price-earnings hit a band of 10-12 times. After being steadily whittled down this year, Sensex companies are expected to close 2011-12 with Rs 1,160 in earnings (Bloomberg consensus estimates). This factors in just a 6 per cent growth over last year. Assuming these earnings estimates hold, a PE of 10-12 times leads to a Sensex floor of 11,600 to 13,920.

Looking ahead

However, these profits will soon be history. With just three months left to the close of this fiscal, investors are sure to be already focussing on the earnings picture for 2012-13. The Bloomberg consensus estimates today put the 2012-13 earnings for Sensex companies at Rs 1,321.

Given that further pain could be in store for companies from recent rupee depreciation, there could be further cuts in that estimate. Slashing it by a drastic 10 per cent and applying a PE band of 10-12 times to it, leads us to a Sensex floor of 11,890 to 14,268.

Low base effect

While a Sensex floor of 11,890 appears quite alarming as we are poised at 15,500 levels, the Sensex may not fall that far this time round. For one, there is plenty of cash on the sidelines that appears to be waiting to enter Indian stocks at the right opportunity.

When the markets began their plunge in January 2008, it was at the end of a raging bull market; retail investors had poured money into equities and FIIs had already made net purchases of $12 billion in equities the previous year. 2011 has been very different. Retail investors have stayed largely away from equities and invested, instead, in gold and bank deposits. FIIs have made barely any net purchases in stocks this past year and have been sitting pretty on debt. A fall in interest rates or a correction in gold prices could trigger a re-allocation to equities.

Two, the stock market correction of 2008 started when earnings of Indian companies and optimism about them were at a high. The combined earnings of Sensex companies in January 2008 had expanded by 20 per cent year-on-year. When earnings began to slide with other macro indicators, it resulted in a double-whammy of lower profits commanding lower multiples as well. Today, pessimism is rife in the analyst community and an earnings downgrade cycle is already under way. Therefore, the damage to PE multiples may be less drastic than it was in 2008.

All this number-crunching suggests that the downside risks to the market from here may at best be 9-10 per cent, while the return potential can be quite high. As the markets grind down further over the next few weeks or months, those of you with three-year plus horizons should accumulate stocks.

Don't give in to panic, stick to blue-chip stocks/diversified equity funds and phase out your purchases over three-four instalments. For those valiant enough to take the plunge, up ahead may be a life-time opportunity to shore up your long-term wealth.

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