With the Sensex scaling new highs, all eyes are firmly set on the forthcoming quarterly results. Bulls look for affirmation of strong growth in the corporate earnings while bears are waiting eagerly for the slightest sign of a slowdown to pull the plug.

Even the finance minister had said recently that the second quarter numbers will be keenly watched to see if stock prices are moving in sync with the fundamentals of the economy. Fingers are crossed. But in all likelihood, wishes of second quarter earnings surprises resulting in series of earnings upgrades may not bear fruition.

Even in the recent past, stock prices have been driven by fund flows, rather than by any significant rise in earnings expectations. That there is little sign of liquidity abating is one reason not to despair. There are other reasons too.

Corporate earnings growth for the second quarter is expected to grow at around 15 per cent on a year-on-year basis. Had it not been for oil marketing companies, which are unable to cover even their costs due to the government's reluctance to increase retail prices, growth could have been a lot better.

This quarter, sectors such as technology, telecom, metals and engineering stocks are likely to lead the pack. Banks should display mixed results with big private sector banks most likely to show strong growth in earnings.

Earnings growth to slow

For the current year and the next, analysts are still hopeful of a double-digit growth but significant deceleration isn't ruled out.

In a recent research report, Citigroup forecasts Sensex (excluding oil companies) to rise 16.3 per cent in FY06 and 12.8 per cent in FY07. Motilal Oswal, downgraded its earnings estimates by 2 per cent for the current year.

In the last four years, earnings have grown around 25 per cent per annum primarily driven by strong sales growth and cost rationalisation efforts. While a booming economy drove up sectors like autos, high disposable incomes meant more business for companies in areas like telecom, passenger car sales, two-wheelers, retail chains and even retail banks.

Rising commodity prices, particularly metals and chemicals, meant accelerated growth for these companies as well. For most companies, earnings grew at a faster clip as lower interest and salary costs apart from other cost rationalisation efforts paid off. What now?

While there isn't a major cause for concern on the topline growth, not all sectors look to be on a firm footing. Surely, sectors like autos, capital goods, consumer, media, telecom and software services company will show robust sales figures.

However, sales growth may taper down a bit in auto and telecom, as it may be difficult to show accelerated growth after two consecutive years of phenomenal growth. On weak ground are companies in the commodity sector, as they seem to be close to the peak of the cycle.

Both petrochemicals and metal prices are close to peaking out. Topline growth may not exceed 15-18 per cent overall in FY06 and could well be another notch lower in FY07.

There are several reasons why earnings growth could trail topline growth going forward. Currently, most industries whether it be cement, steel or auto are working close to full utilisation levels.

Several companies have also laid out their expansion plans. The effect of this expansion will be seen in the balance sheet in another year or so, possibly from FY07 onwards, affecting capital efficiency. Obviously, return on equity will come down from the current levels.

So what about the markets?

Decelerating earning coupled with the accelerated rise in stock prices will surely render stocks getting overvalued in double quick time.

Domestic research firm Motilal Oswal which has been consistently bullish on the markets even since the first leg of the bull market began in May 2003, had put a one-year target of 8281 for the Sensex in July, 2005. The target has been achieved in one quarter. But the firm has not revised its Sensex target and is waiting to watch how corporate earnings numbers roll out.

According to analysts, the market can sustain at current levels only if flows are equally strong going forward. For now, foreign investors across the global are keeping faith in Indian equities with funds launched in Japan, Korea and Taiwan, pumping in big money.

In September, India garnered the largest share of foreign institutional flows into emerging markets. Interestingly, even on days of sharp falls in the index in the recent past, FIIs have been net buyers in the market. While sentiment continues to be positive, the reality is that valuations are no longer favourable.

Weakening outlook

Several foreign broking houses including prominent ones like CLSA and UBS have already downgraded Indian equities. Anticipating a correction, most of them now have a neutral or underweight rating on India.

According to some analysts, Indian equities are among the most expensive. Considering the price-earnings multiple, Indian equity is the third most expensive globally and second most expensive in Asia.

Based on another conventional measure of valuations - price to book value - India is the most expensive at 4.8, compared to a world average of only 3.

Though the high valuation can be justified to some extent because of the relatively better quality of earnings - the return one equity in India is among the highest at 20 per cent plus - the question is how much will global investors pay for growth and quality.

Retail investors, especially those who have missed out the rally so far, and domestic mutual funds, which are flush with funds are providing buying support on every dip. No wonder the markets have bounced back with a vengeance after every correction.

A melodramatically titled "Bharat P/E Vs Videsh Vertigo" report by JP Morgan puts a target of 9900 (Sensex) by the end of 2006. The firm's strategist, Adrian Mowat argued that India is in the third stage of "sellers' strike".

"The shift from cash and bonds into equities and other real assets has started. With household and institutional exposure to equities still low this secular trend is likely to be the prime support for the market," the report added. With bond yields significantly below nominal growth it is still rational for Indian savers to switch to real assets such as equity. In an earlier report, Mowat had reasoned that domestic investors in India would be willing to bear a higher P/E than foreign investors.

However, it may be premature to count on household savings flowing into equities in a major way. A change in the household savings pattern may take a while, as the mindset of an average Indian saver is still to invest in safe assets.

Retail investors have not yet got out of the rude shock after the last two booms exploded with the unveiling of scams. Only a sustained rise in equities for a good length of time can get the average Indian saver to take a walk down Dalal Street [Get Quote].

Second quarter expectations

In the second quarter too, topline growth could taper a bit and earnings growth momentum could decelerate. Moreover, the rising cost of raw materials in several manufacturing companies is likely to put pressure on margins. Cement, FMCG, engineering and capital goods are likely to show good numbers.

Automobiles: After a lean first quarter, auto sales are likely to be better in the September quarter. Commercial vehicles and passenger car sales showed a rebound in Q2. Tata Motors [Get Quote] topline could grow by 12 per cent while bottomline growth could be marginally better.

Maruti [Get Quote] sales growth is expected to be around 10 per cent while net profit growth could be much stronger owing to high realisations and operational efficiencies. Two-wheeler makers, Hero Honda and Bajaj Auto [Get Quote] should see sales growth of around 20 per cent; the latter may do even better. Net profits growth could be lower at around 15 per cent.

Banks: Growth in net interest income is likely to be strong driven by robust credit growth - 30 per cent last quarter. Core earnings growth should be good, because of lower provisioning for NPAs and saving on staff costs (for PSU banks).

But then treasury gains will be nil or minimal but there should be no more HTM (hold to maturity) transfer hits either. Motilal Oswal Securities expects Bank of Baroda [Get Quote], Punjab National Bank [Get Quote] and Corporation Bank [Get Quote] to record a decline in EBITDA.

UTI Bank [Get Quote] should be an exception recording a five times jump in EBITDA as the bank recovers from the depressed base of last year when it transferred a bulk of its treasury portfolio to hold to maturity. ICICI Bank [Get Quote] is estimated to show a 30-40 per cent growth in net interest income and about 25-30 per cent growth in net profit, according to different analysts.

Oil and gas: The worst hit will be the oil and gas sector stocks, like Indian Oil [Get Quote], Bharat Petroleum and Hindustan Petroleum, due to product prices falling short of their cost.

Oil companies could show as much as 25-30 per cent growth in topline driven by higher crude prices. But oil marketers are likely to post poor numbers. While HPCL [Get Quote] and BPCL [Get Quote] may well be in the red, IOC could see a 70 per cent decline in earnings. However, firm regional refining margins should hold refining companies like Reliance Industries [Get Quote] and pure refiners like Chennai Petro in good stead.

Compared to the same quarter previous year regional refining margins are up 16 per cent. Reliance Industries is expected to show earnings growth of over 25 per cent even though petrochemical margins may be under stress, based on consensus estimates.

Cement: Cement units did not have to effect the usual price cuts during the rainy season this year due to a comfortable offtake. Cement topline growth rates are likely to be down as monsoon affected sales this quarter.

However, compared to last year volumes are likely to be nearly 10 per cent higher while realisation could be 3 per cent more. ACC is expected to see earnings grow by over 35 per cent while Gujarat Ambuja [Get Quote] could see over 30 per cent growth. Grasim [Get Quote] may see a decline in earnings on account of lower VSF and sponge iron prices.

Capital goods/Engineering: Capital good companies should keep up their growth momentum. Revenues growth should be over 20 per cent on an average on the back of good order book.

Margins are likely to be stable despite rising raw material costs. State-owned BHEL is expected to see a 40 per cent growth in operating profit on the back of a 15 per cent growth in topline. Net profit growth could be around 20 per cent. Private sector biggie Larsen & Toubro could see a profit growth of around 40 per cent.

FMCG: Buoyed by strong growth in volumes, FMCG companies should post topline growth in excess of 10 per cent. FMCG companies should see margins improve a bit reflecting the improvement in pricing environment.

Behemoth Hindustan Lever [Get Quote] is estimated to see a sales growth of 10 per cent though bottmline growth could be in the range of 15-20 per cent according to various estimates.

Tobacco major ITC is expected to see a topline and bottomline growth of over 20 per cent. Dabur [Get Quote], Godrej [Get Quote] Consumer, Marico, Nestle [Get Quote] and GSK [Get Quote] Consumer are also expected to show earnings growth of over 25 per cent. Analysts are divided on Britannia [Get Quote] and Colgate.

Technology: Tech companies should post the second fastest growth rates next to telecom. Driven essentially by high business growth, top-rung tech companies, which include Infosys [Get Quote], Wirpo and TCS [Get Quote] are likely to show earnings growth of over 10 per cent (sequential).

Since the rupee weakened a bit this quarter, currency gains will boost earnings growth, though only marginally. Among the smaller companies i-flex and Datamatics Technologies [Get Quote] are likely to show spectacular growth but HCL Technologies [Get Quote] may disappoint.

Media: Among the media companies, Television Eighteen is expected to see over 50 per cent growth in topline and bottomline. Zee Telefilms is expected to see earnings growth around 15-20 per cent. TV Today may continue to bleed while NDTV is expected to show decline in earnings.

Metals: Hindalco [Get Quote], Sterlite Industries and Hindustan Zinc [Get Quote] are expected to show over 40 per cent earnings growth thanks to firm prices and better margins. Hindustan Zinc should post about 60 per cent growth in sales as its expanded capacity commences this quarter resulting in high volumes sales. Despite the fall in steel prices, Tata Steel [Get Quote] and Jindal Steel should show growth of around 10 per cent.

Textiles: The textiles sector is expected to post good results due to export demands. Textiles companies should see sales growth by 25 per cent driven by strong exports pick up.

Telecom: Telecom is likely to remain the fastest growth sector. Bharti should show good growth momentum driven by strong growth in subscriber base. Earnings growth is likely to be 65 per cent.

Pharma: Pharma companies should also do well except Dr Reddy's which is still a few miles away from a serious turnaround. Even one time darling Biocon [Get Quote] and Matrix is likely to disappoint.