Liquidity, not earnings growth, driving stock rally

Sensex up 18% from late-August lows against 6% rise in underlying earnings during the period

The current Sensex rally, which has propelled the index to its highest close, has been driven by valuation expansion rather than earnings growth. The Sensex is up 18 per cent from its lows in late August this year against a 6 per cent rise in the underlying earnings of Sensex companies during the period.

The index is up 8 per cent since January this year compared to a 4.5 per cent increase in the underlying earnings during the period. The result has been a sustained expansion in index valuation multiples. The Sensex is currently trading at 18.3 times the trailing 12 months’ earnings of its constituent companies, up from less than 17 times in the last week of August and 17.7 times at the beginning of the year.

The analysis is based on the various valuation ratios reported by the BSE (Bombay Stock Exchange) for its indices at the end of every trading day. The BSE-provided price-earning multiple has been inverted to get the underlying earnings per share for the index on a trailing 12 months’ basis.

Analysts say the current valuation can be justified only if corporate earnings growth gathers steam during the second half of the current fiscal and beyond. “Many investors expect an earnings upgrade for the second half of FY14 and the next financial year. That, in turn, will depend on a recovery in economic growth and a favourable macroeconomic environment,” says G Chokkalimgam, managing director, wealth, and group chief investment officer, Centrum Capital. As of now, there has been no sign of a revival in corporate earnings. In the second quarter, the combined net profit of 600 companies that have declared their results so far fell by 4.4 per cent despite a 14 per cent rise in their net sales over the corresponding period last year.

This has made some analysts sceptical about the sustainability of the current rally. “The current rally is largely liquidity-driven with foreign institutional investors bidding up the prices of select stocks in the hope of better earnings growth going forward. If it doesn’t materialise, the markets may correct at the first whiff of bad news,” says Dhananjay Sinha, co-head institutional equity at Emkay Global Financial Services.

In the last two months, foreign institutional investors (FIIs) have invested around $4.5 billion in the Indian equity market, more than what they had pulled out in the previous three months. In June-August, FIIs were net sellers on Dalal Street as they pulled out a total $3.6 billion on fears of a stimulus withdrawal by the US Federal Reserve. In all, FIIs have pumped $15.8 billion in Indian equities during the current calendar year so far, most of it coming in the January-May period.

In the last two years, a bulk of the incremental earnings growth has been accounted for by select companies in the information technology, pharma, fast-moving consumer goods and private sector bank spaces. Analysts say companies such as TCS, Sun Pharma, Dr Reddy's Labs, ITC, Hindustan Unilever, HDFC Bank, HDFC and ICICI Bank should either maintain their earnings momentum or new companies would take their place to enable the Sensex achieve new highs.

“Investors had put most of their eggs in a few baskets, which can’t continue to deliver quarter after quarter. Unless other heavyweights such as Reliance Industries, Tata Steel, L&T, BHEL and State Bank of India start contributing, the earnings funnel will keep getting narrower — increasing the downside risk for investors with each high,” says Sinha. Bulls have, however, been encouraged by the first flush of second-quarter results.

“Most of the results so far have been above expectations and there have more upgrades than downgrades. The markets may see new growth drivers next year such as telecom, which will support earnings and valuations,” says Rikesh Parikh, vice-president, institutional corporate broking, Motilal Oswal Financial Services.

According to him, the Sensex is fairly valued right now, with the possibility of another 5 per cent upside by March next year, based on his firm's forward earnings estimates for FY15.