Optimistic earning estimates, lower liquidity raise alarm in stock market

RBI governor warned earlier this week about the rally, citing the disconnect between the markets and the economy as well as expectations that bad-loan ratios at lenders will almost double this year

Strategists are cautioning against the blistering rally in India’s stock market as the country braces for its biggest annual economic contraction on record.

Overly optimistic earnings estimates and a reduction in liquidity pose the biggest threats to the scorching pace of gains, strategists from Nomura Holdings Inc. to Kotak Mahindra Asset Management Co. warned. The S&P BSE Sensex Index has risen for 10 straight weeks -- its longest winning streak since 2009.

The nation’s central bank governor warned earlier this week about the rally, citing the disconnect between the markets and the economy as well as expectations that bad-loan ratios at lenders will almost double this year. The Sensex extended gains after that and is now trading at a record valuation of about 24 times forward earnings.

To be sure, high-frequency indicators are showing signs of revival in the pandemic-battered economy. Foreign investors have also supported the rise, plowing in $23 billion into the nation’s stocks last year as they pulled money from all other major economies in Asia other than China.

“Sustainable demand is key, and extrapolating some of the recent growth trends may lead to disappointment,” as it comes on top of a low base, Saion Mukherjee, a Mumbai-based analyst at Nomura, said. Another risk is “a rise in inflation, leading to lower liquidity support.”

The Sensex is expected to remain flat over the next 12 months, according to consensus analysts’ estimates compiled by Bloomberg. That’s despite predictions that per-share earnings will grow 40% and 16% for BSE 500 and Sensex members, respectively, in 2021.

Inflation is a concern for equity investors as the global economy improves because it can lead to interest rate hikes and can divert flows from stocks into bonds. India’s central bank has already taken its first step to unwind stimulus measures.

“When interest rates are falling, equity valuation goes up, and when liquidity is rising, profitability in business activity correspondingly can go up. It can work in the reverse direction as well,” said Nilesh Shah, managing director at Kotak Mahindra Asset Management.

Aside from inflation, any tightening of fiscal stimulus in the annual budget reading in February could also hurt sentiment even though the earnings outlook is robust, said Mahesh Patil, chief investment officer for equities at Aditya Birla Sun Life Asset Management Co.