Sell the year-end rally? It might just make sense

Things could actually get worse in the Indian equity markets before they get better. That’s the grim warning issued by Bank of America Merrill Lynch (BoAML), which said the Sensex could hit a low of 14,500 in the next six months on the back of high interest rates, a slowdown in the global economy and slow pace of investments before rising again.

As Firstpost noted earlier , the Indian markets have been the worst-performing market this year, falling one-third in US dollar terms. Even brokerage firm CLSA predicted that the Sensex could plunge to 14,000. Indian stock markets have notched up negative December returns once once in the past 20 years, 2011 could experience a rally too on expectations that interest rates hikes might be paused and inflation has hit a peak.

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However, the brokerage firm advises investors to sell the rally keeping in mind the poor GDP numbers and outlook on corporate earnings.

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In the year ending March 2012, GDP growth is expected to be drop to as low as 6.8 percent by BoAML, adding that it could even fall to 6.5 percent.

Meanwhile, earnings downgrades for Indian companies could continue through the next year as profits are expected to grow by just 10 percent from the 15 percent estimated earlier.

Overall, BoAML expects the Sensex’ earnings per share (EPS) to slip to Rs 1,200 from the previously estimated Rs1,275.

In turn, valuations of stocks could also fall.

The market’s price-earnings (P/E) multiple based on estimated earnings for the year ended March 2012 is currently 13.2 – lower than the average of 14.2. Higher the P/E multiple, the more expensive is the stock or market.

While the current P/E might make equities look cheap, a further earnings downgrade won’t leave those valuations looking cheap for long.Indeed, given the slowdown, the market should be trading at a discount (lower) to its average P/E multiple.

Besides, compared with other emerging markets, Indian equities are still expensive (trading at a 27 percent premium). In the past 10 years, that premium has been around 17 percent.

While a halt in interest rate hikes could be a positive for stocks, historically, the December rally has never made money for investors. For markets to actually start improving, reforms need a concerted push, which will then translate into investments and improve corporate earnings.

In this context, BoAML continues to depend on defensive stocks (but not consumer goods). The brokerage prefers to bet on pharma stocks such as Sun Pharma and Lupin. In terms of sectors, its preferred bets are rate-sensitive sectors like financial services and automobiles.

BoAML’s top picks include HDFC Bank, ICICI Bank, Maruti and Hero Motocorp. Among mid-cap stocks, the brokerage prefers to bet on Apollo Tyres, Dish TV, Havells, Exide and Manappuram.

The top underperformers, in its estimate, will be Bajaj Auto, Tata Steel and Ambuja Cement.