The easy money has been made

Equity market performance over the past six months has been extremely buoyant, with the Sensex and BSE Midcap Index gaining 25 per cent and 43 per cent, respectively.

This was driven by rising expectations of a turnaround in the economy as the new Government took charge and declared its focus on getting back to a stronger growth trajectory. But in the last two months, the market and benchmark indices have stayed flat.

The Budget and June quarter results have forced market players to do a reality check. Both events have led to moderation of expectations for a quick turnaround.

Though the Budget 2014-15 did not see big-bang reform, it revealed the focus on pro-growth and pro-development policies.

Steps on reviving the investment cycle are visible from the grant of environment clearance to eight SEZs, premium rescheduling for 16 road projects, approval for nine power transmission projects. and so on.

Furthermore, the Cabinet cleared a hike in the FDI cap in defence to 49 per cent and 100 per cent FDI in railway infrastructure.

On the macro-economic front, industrial production growth of 4.7 per cent for May came as a positive surprise and so did the decline in CPI to 7.3 per cent in June.

These are positive signs from a long-term point of view. Quarterly earnings have been mixed.

The dispersion within Sensex companies was significant, with the number of companies missing estimates higher than those that surpassed expectations.

Domestic-led cyclical sectors have disappointed, though overall earnings have been in-line with estimates.

As the incremental steps taken by the Government percolate to the company level, we expect to see earning upgrades taking place through 2014-2015.

In this context, though the equity market will gain in the medium term as it derives strength from the improving economic growth and corporate earnings growth trajectory, it should consolidate in the near term. The re-rating for companies in the mid-cap space has been far sharper, leading to compression of valuation discounts versus large-caps.

Currently, the forward price-earnings ratio of the BSE Midcap Index is 14.3 times, versus 15 times for the BSE Sensex. The outperformance of mid-tier companies versus large-cap companies may continue. But given the easy money made so far in the mid-cap space, further upside will be stock-specific, driven by earnings upgrades. We believe the Government’s pro-growth approach will aid the revival in the economy and bodes well for equity markets. While the market appears fairly priced, gradual improvement in macro indicators will drive further re-rating ahead of the earnings upgrades.

Also, moderation of crude prices (due to reduced geo-political risk) and additional inflows from domestic retail and foreign institutional investors will drive broader markets.

Investors can use any weakness in the near term as an opportunity to increase equity allocations, with a two-three year horizon in mind.

The writer is Co-Chief Investment Officer, Birla Sun Life AMC

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