A narrow rally

Inflows into equity funds have eased sharply

It has been a strange year for stock market investors. Earnings growth has been deeply disappointing for the past six or seven quarters. Retail investors, who are mainly invested in smaller stocks and in active funds with small/midcap mandates, may also be losing confidence. Mutual funds tracking smaller stocks have yielded low or negative returns since January this year, and this segment of the market disappointed last year also. Inflows into equity mutual funds eased to Rs 1,311 crore, down 78 per cent in November compared with the previous month. This has been the lowest inflow since mid-2016 and redemptions are also high at Rs 16,268 crore.

 
The large caps indices are up, with the Nifty and Sensex having registered gains of 11.07 per cent and 13.4 per cent, respectively, since January. But small caps and midcaps are down. Even in the large cap segment, it has been a handful of stocks that have contributed disproportionately to index gains. Just 10 of the 30 Sensex stocks have contributed over 90 per cent of the gains to that index. But while earnings growth has been disappointing, the stock market has received support from institutional investors this year. Foreign portfolio investors (FPIs) have pumped Rs 92,300 crore into equities since January. Domestic institutions and mutual funds have also been consistently positive. Part of this interest in equity has been driven by a global trend of low interest rates and easy money. The US Federal Reserve has cut the Fed-funds rates thrice in 2019; the European Central Bank has a negative policy rate and the Bank of Japan has an ongoing quantitative easing programme as well as a negative policy rate. Hence FPIs have been willing to look at riskier emerging market assets, such as Indian equities. Domestic investors have been similarly influenced by five successive policy rate cuts of the Reserve Bank of India. However, earnings growth has been so poor that only a handful of stocks have looked investment-worthy. Hence the narrowing of the market.

 
Valuations are at alarming levels. The Nifty is trading at an average price-to-earnings (PE) ratio of 28 and the midcaps index is at a PE of 32, while the Nifty small caps index is at a PE of 63. Given that earnings growth is in single digits, these valuations are far too rich. There have been a large number of earnings downgrades as well, and economic growth projections have been scaled down. It seems unlikely that earnings growth can accelerate at a pace that justifies these high valuations. An examination of fund flows in November suggests that some of the smart money is now moving into low-risk assets, such as short-term debt and the money market. The country may see a future pattern of higher equity fund redemptions coupled with higher investments in such low-risk assets.

Innovative instruments like the Bharat ETF, which holds public sector undertaking bonds and is effectively treated like a basket of sovereign debt, are also likely to attract the more risk-averse.
 
The optimists would be hoping for some positive domestic triggers. There have been some positive developments at the global level. The Fed released an optimistic prognosis for 2020 and the hoped-for cessation of the US-China trade war will add some growth impetus. The recent UK election outcome removes much of the uncertainty around Brexit. Now it’s up to India’s policymakers to create a convincing case for a domestic rebound by addressing the causes of the current malaise.