Most external observers can be forgiven for automatically assuming that Indian equities must be dirt cheap and at all-time valuation lows. After all, the markets are down by more than 50 per cent in 2008, and if you look at midcap indices the drawdown is over 70 per cent. With such price destruction how can companies not be historically cheap? After all, the Indian economy is still growing at 6 per cent and we do not have the excess leverage issues of the West.

The reality, however, is that for most money managers they are still not finding distress values in the equity markets, especially in the higher-quality and large companies. This is not yet 2003, when the markets really looked cheap, pretty much across the market cap spectrum.

There are pockets of really cheap valuations in India, among the midcaps for example, or in certain sectors, but it is difficult to come up with a list of stocks where you have high absolute conviction in the valuations and where you can deploy very large chunks of capital.

Take a look at the valuations from a numerical perspective.

• India's absolute valuations are near historical lows using earnings-based metrics, though not on dividend- and price/book-based measures.

The Morgan Stanley composite valuation indicator is at its third lowest level ever, with the market being cheaper only in September 2001 and November 1998. MSCI India PE is the lowest it has ever been.

• Broader measures of value such as market cap/GDP have also normalized, with the ratio dropping from 160 per cent at the peak to near 60 per cent today. However, at 60 per cent we are only at the world average and still the highest among the BRIC countries.
• On any interest rate-based valuation measure like the bond/equity yield gap, India has never been cheaper. The moot point here is, of course, the sustainability of these bond yields.

Can a country with a fiscal deficit of 10 per cent of GDP and in today's constrained global capital flows environment have G-Sec yields below 6 per cent? Like any relative valuation measure, these interest rate valuation tools suffer from the problem that they can seem cheap because they are being compared against something overvalued. In this case equities look cheap because bonds are overvalued.

• Relative to other emerging markets, India is now no longer the most expensive market in the EM world, an honour it held for most of 2006 and 2007. Having said that, we are still in the upper third of markets ranked by valuation, still far away from 2003 (when the last bull market began), when Indian markets were trading at a discount to the rest of the EM universe.

There are, however, a couple of issues with the valuation measures discussed above. All the earnings-based measures suffer from the problem that earnings are coming off a huge surge in the past five years.

As Morgan Stanley points out, the BSE Sensex constituents have grown earnings fivefold in the past five years. The earnings quality has also deteriorated, in terms of percentage other income, cash flow conversion etc.

There is also tremendous uncertainty on the earnings outlook for 2009-10. Thus investors are uncomfortable using earnings-based valuation tools as there are worries on what is the real earnings power of companies. I am not talking about fraud here but simply the fact that earnings have risen as a percentage of GDP, and as is typical in strong economic cycles, companies have potentially over-earned compared to the sustainable profitability of their underlying business model. If companies have over-earned in the past few years how does one adjust for this?

Over the last few years, we had a virtuous cycle of rising capacity utilization, falling rates, significant pricing power, easy access to capital and surging growth rates. All this combined to supercharge earnings and capital efficiency ratios.

Unfortunately most of these factors are now in reverse, with the inevitable consequence on earnings. Investors are beginning to realize that in many companies earnings are far more cyclical than they had realised. Strong economic growth can disguise inherent cyclicality, and once exposed, cyclical earnings attract lower multiples.

Many supposedly secular growth stories will be exposed as cyclicals which benefited from the huge tailwind that India had over the last five years.

Post Satyam [Get Quote], one also gets the feeling that promoters will be more careful about balance sheets and earnings statements. I would not be surprised to see a slew of write-offs and other adjustments as auditors get tougher and force more disclosures and tighter standards.

With the markets being in a bear phase, there is also every incentive for companies to clean up their books and take all write-offs etc, as unlike in a bull market, supernormal earnings will only attract scrutiny and suspicion.

If one were to move away from earnings-based models then the two most commonly used measures - dividend yield and price/book - while screening to be cheap, are not near all-time lows. In both cases the markets will have to drop by about 25-30 per cent to get there.

Thus while the market may be near all-time lows on earnings- and interest rate-based valuation models, investors are not convinced on the sustainability of current yields or earnings, and on non-earnings-based valuation tools the market is not yet at distress levels.

On a stock-specific level where there is clarity on earnings, valuations are not cheap, and those stocks looking cheap have absolutely no earnings visibility. All you need is one bad quarter for erstwhile cheap stocks to suddenly start looking expensive.

Another similar issue as to why investors are nervous about buying today is the sheer scale of economic volatility. One has never seen the economic assumptions on which one has based a buying decision turn so dramatically and so quickly. If, for example, one had bought an auto ancillary, you would never have modelled that truck sales in India would decline by 60 per cent in this quarter or that car sales in the US would go to mid-1980s' levels.

Almost no one would build in such scenarios. Thus there is unparalleled uncertainty on the future course of earnings, and investors want to build in the worst they can imagine and then want stocks to be cheap off those worst case assumptions.

We are coming off a huge bull cycle in 2003-2007. Given the quantum of stock price appreciation, it is logical that the markets will only bottom out with time and when they appear very-very cheap. India has probably not yet reached that stage of extreme price attractiveness - the markets are cheap, yes, but not yet distressed.

With the passage of time as we get more comfortable with the economic outlook, one may need less margin of safety on earnings and have a greater willingness to pay up for growth. Investors have to be willing to extend their time horizons again and not become obsessed with the next quarter. For that we need the elections out of the way, and some semblance of normality globally.