The last two years have been unusual in that there has been a massive global divergence between fundamentals and equity valuations. While there has been a global recession, share prices have risen across most markets.

The reason for prices rising in the face of economic weakness has been a flood of liquidity.

The US Federal Reserve has pumped out about $ 85 billion a month in the name of quantitative easing; the European Central Bank has also maintained an easy money stance and more recently, the Japanese have started to ease money supply.

That liquidity has to go somewhere and a large proportion has ended up in equity. While equity isn't massively over- valued in India, it is certainly on the high side of justifiable. Similar situations hold true for the US and many European markets.

Could there be a further upside to stock market prices if there is a growth revival? This isn't necessarily the case. If the liquidity dries up or the taps are tightened, equity prices could slide even if growth improves substantially. However, a divergence in the direction of under- valuation would be more welcome than the current divergence in the direction of over- valuation.

What is fair valuation for the Indian market anyway? Answering that question is difficult. First, consider share prices and valuations. The major indices like the Sensex and Nifty have recently tested levels seen in early 2008. In 2008, the indices were running at valuations equivalent to 25 PE or higher. Now, the valuations are at about PE 18- 19 for the same index levels.

While 18- 19 PE is not cheap, it is not as over- valued at 25- 26 PE. On those grounds, an investor would be more comfortable now than in 2008. However, the compounded earnings growth across 2007- 08 to 2012- 13 has been just about 6- 7 per cent for the Nifty. If you factor in the high inflation across this period, earnings growth net of inflation effectively translates to near- zero. By that logic, the market is seriously over- valued.

By comparison with rupee interest rates in the 7- 8 per cent zone, fair valuation would be somewhere between PE 13- 14 or perhaps, a little lower. Of course, the key buyers have been FIIs who are looking at much lower hard currency rates in the 1- 3 per cent range. Even with currency risk, the lower hard- currency rates justify higher PEs, assuming that India exposure is desirable. Incidentally, although smaller stocks and mid- caps have delivered less in the way of capital gains than large stocks, they also have poor overall earnings growth rates. The lower capital gains is easily explained by the fact that FII exposure to smaller stocks is low or nil. The earnings record is more difficult to explain. One can infer larger businesses are less vulnerable to recessive conditions and high interest rates. But it would take us far beyond the scope of this column to prove it.

Now, if there's a pickup in macro- economic growth rates and a fall in inflation as well, earnings growth could accelerate considerably. In analyst jargon, there's room for positive surprises. In the Q3, 2012- 13, GDP growth dropped to 4.5 per cent, which was the lowest growth rate in a decade. Overall, 2012- 13 saw GDP growth of somewhere between 5- 5.5 per cent. A bounce above 6 per cent in terms of 2013- 14 GDP growth is quite likely and it is possible that GDP growth could climb back above 7 per cent by 2014- 15.

Inflation is also showing signs of cooling off and the interest rate cycle is clearly headed down. The RBI has cut the Repurchase rate by 125 basis points in the past 12 months. It could cut by another 225- 250 basis points over the next two years before the interest rate cycle bottoms out.

If the economic cycle hits the sweet spot, we might see earnings growth picking up till around 15 per cent, while rupee interest rates drop to say 4- 5 per cent by 2014- 15. Assuming similar liquidity conditions, this would give the Indian stock market a considerable upside.

However, one cannot assume similar liquidity conditions.

The US may cut back on its QE sometime in the next 12 months, and maybe a lot earlier. Nor can one assume a similar risk- on attitude where Indian assets are concerned.

A certain amount of political turbulence in guaranteed over the next couple of years. The FIIs may have been prepared to risk investments into a country with an apathetic and corrupt, but stable regime. They might cut exposures drastically if the alternative is a succession of apathetic, corrupt and unstable regimes. If that's the case, equity prices would fall even as the fundamentals improve. This would actually be an ideal situation for a long- term investor.

Happy Investing!!

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