Investors were demanding an unusually low risk premium in 2007
: During the bull market of the past four years, share price increases consistently outpaced earnings estimate rises. This was because investors were regularly lowering the risk premium they demanded from equities.
Put another way, the expected return from shares was falling, as was the expectation of volatility in growth (of cash flows to equity investors, i.e., dividends). By January 2008, the equity risk premium (ERP) implied by the constituents of the BSE Sensex using our residual income model and the 10-year bond yield as the risk-free rate had dropped to 4.1%.
That level, in our view, did not compensate long-term investors enough for the risks they were taking while buying Indian equities.
• Equity risk premium is normalizing: The near-30% correction in equities since January 2008 has been accompanied by a very small downward revision in earnings. Thus, the opposite of what happened between 2003 and 2007 has occurred over the past three months, i.e., the equity risk premium implied by share prices has risen.
Our residual income model suggests that the risk premium for the BSE Sensex is at 5.6% - a level we think almost adequately compensates investors for the risks they take in India.
We think that this rise in risk premium has been led by risk aversion globally and the compressing growth and higher inflation outlook at home. However, investors will do well to note that the growth slowdown and the rise in the inflation rate are both cyclical phenomena and not structural changes in India's long-term story.
To that extent, the normalization of the risk premium represents an opportunity for long-term investors even as the market faces short-term risks. Incidentally, using the 10-year trailing return from the BSE Sensex, long-term investors have realized an equity risk premium of about 3% as of today (the BSE Sensex has compound at annual rate of 15% since April 1998).
• Our fair value estimate is at risk from earnings downgrades: We undertake our customary quarterly update of our residual income model for the BSE Sensex. The three-stage model, which uses our analysts' bottom-up estimates in the first stage plus our top-down estimates for the second stage and a 6% terminal growth assumption for the third stage, reveals a fair value of 14,540 at December 2008, using a discount rate or expected return of 14% (8% risk-free rate and 6% ERP).
The number is down 2% from our previous fair value estimate (in December 2007) due to
the marginal rise in the bond yield and a slight decline in analysts' earnings estimates as well as the change in the BSE Sensex constitution (JPA replaced BJA).
Our residual income model implies a long-term EPS growth rate of 15%. The fair value of the market is at risk if earnings estimates are lowered, as we think they may be. Currently, MS analysts are estimating growth rates of 19% and 23% for F2009 and F2010, respectively, for
the BSE Sensex constituents on an aggregate.
If these numbers come in at 12% and 18%, as we think they will from a top-down perspective, the BSE Sensex fair value slips another 150 points.
• What are the near-term risks to the market?:
The three key risks are that the market receives an adverse policy response to rising inflation (like a rate hike), downward earnings revisions (led by the growth slowdown and off-balance-sheet losses), and a collapse in retail investor sentiment
(mutual fund flows suggest that retail investor sentiment is still okay even though speculators' sentiment is approaching "fear" territory).
These seem to be precisely the factors that the market has not yet priced in. The markets also needs global financial market sentiment to settle and valuation dispersion to narrow
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