Morgan Stanley: Market Is Nowhere Near A Bubble

From a top down perspective there does not appear to be any major discrepancy in what the market is pricing in relative to our expectations. Since we do not have the consensus view for nominal growth, long term earnings and long term return expectations, it is difficult for us to judge how the market is perched relative to the consensus expectations. From our perspective, we feel comfortable that equities are not over zealous about the coming growth, inflation, earnings or returns.

Key Debate: While the indices have made progress this year, they have defied expectations of steep corrections. The key question is what exactly is in the price in terms of growth, interest rates, inflation, long-term earnings and long-term returns.

Our Evidence: The data we track suggests that the market has already priced in a slowdown in nominal growth just the way it had priced in an acceleration in growth in late-2009. The market seems to be expecting nominal industrial growth to drop to around 14% by the end of 1Q11 – in line with our economist's forecast and compared to the last print of approximately 24%.

Likewise, the market is also pricing in a normalization of the real rate environment. Current real rates (using the wholesale price index inflation and 91-day yields) are at -3.4%. We expect some moderation in inflation in the coming months and a steady rise in short term yields. Hence, we believe that real rates will likely rise to 0.5% by March, 2011. This appears to be what the market is pricing in.

Historically, we have used an equity risk premium of 6%. This is precisely what the market is currently indicating (using our residual income model for the BSE Sensex) which means that the market's long term valuations are at around fair level (relative to our view). At the current 10-year bond yield of around 8%, this signifies a long term return of 13.6%.

The long term EPS growth implied by the MSCI India index is 14% which looks just about fine to us (just below the number we use in our residual income model). Furthermore, about 64% of the MSCI Index value is being assigned to future growth which is higher than the historical average but still puts in equities in good light for long term investors. All-in-all, equity valuations are denoting reasonable long-term earnings and long-term returns.

The market does not look too much forward as far as short term (or quarterly) earnings growth is concerned. Indeed, at times it lags earnings growth and, at other times, it leads – but usually not more than a quarter. However, it is clear that earnings could be a key driver in the coming quarters for short term equity market performance. No doubt earnings revision breadth has weakened in recent months but it is still not at levels which tends to hurt share prices.

Safe Harbor Statement:

Some forward looking statements on projections, estimates, expectations & outlook are included to enable a better comprehension of the Company prospects. Actual results may, however, differ materially from those stated on account of factors such as changes in government regulations, tax regimes, economic developments within India and the countries within which the Company conducts its business, exchange rate and interest rate movements, impact of competing products and their pricing, product demand and supply constraints.

Nothing in this article is, or should be construed as, investment advice.