Bias towards bearishness

Several sharp corrections seem to be on the cards in 2018

As we brace for 2018, let’s run through the arguments that suggest the market is overheated and due for a crash. Then, let’s go through the arguments that suggest the market is not overheated and capable of running up even further. 

The argument for being bearish is simple. Valuations are much higher than the consensus earnings expectations warrant and also much too high in historical terms. The National Stock Exchange’s Nifty is at a current price to earnings (PE) of 26.7 (past four quarters earnings). The Nifty Next 50 is running at PE 37-plus.  The Nifty Smallcap 250 is running at PE 90, while the Free-Float Nifty Midcap 100 is running at PE 53-plus. In historic terms, the Nifty has rarely sustained prices above PE 24 and its long-term mean and median values are near PE 18. Small-caps and mid-caps have never hit such elevated levels. 

These astronomical valuations could be justified if earnings growth expectations were in the same zones. But, earnings expectations are in the mid-teens to high-teens for large-caps and maybe just a little more for smaller stocks.  The Bloomberg Nifty 50 consensus earnings expectations have been cut by eight per cent in the second half of 2017-18 and by 2.6 per cent for 2018-19. 

Perhaps earnings growth could accelerate sharply if the goods and services tax (GST) settles down. But, it would be pertinent to point out that GST took two financial years to settle down in Germany, Holland and Malaysia.  India has a more complicated GST structure than these three nations and a less efficient bureaucracy, too. Rate cuts could also help justify high PE ratios but interest rates are unlikely to come down.  

On the other hand, bulls often cite the market capitalisation (m-cap) to gross domestic product (GDP) ratio, the so-called Buffett Indicator, as a sign that the market could rise further. At the market peak in 2008, the m-cap was 145 per cent of GDP.  In October, it was at 89 per cent of GDP. Well, the m-cap has now edged up to 100 per cent. This leaves some room for price appreciation. The other ratio not yet in the red zone is the price-to-book (PBV) value ratio. That’s in the zone of 3.5 for the Nifty and PBV has edged above six at market peaks. 

Aside from PBV and m-cap to GDP, both arguably capable of climbing higher, there is another argument for the bulls. Inflows remain strong. This has been a record year for mutual funds (MFs), which have seen huge expansion in assets under management. That’s mostly on the back of retail subscriptions and retail (small) investors have also pumped money directly into equities. It has also been a good year for foreign portfolio investors’ (FPI) net inflows, which have supported both debt and equity. If retail investors and FPIs retain their bullish fervour, the market will travel up, regardless of the fundamentals. 

Another positive is that the ill-effects of demonetisation have more or less dissipated. The big bank recapitalisation plan should also make it easier for borrowers to tap credit. Balanced against that, the strong revival in global commodity prices will hurt, especially if fuel prices continue to trend upwards. 

The policy environment could also be vitiated by political considerations. The Bharatiya Janata Party (BJP) is likely to be in perpetual campaign mode until the general election in May 2019. This means Prime Minister Modi will be focused on campaigning than on governance. 

As the BJP lost a lot of rural seats in the Gujarat Assembly elections, it might look to hand out sops to rural voters. A higher MGNREGS allocation and more farm loan waivers, both likely, would impact government finances adversely. A larger-than-budgeted fiscal deficit is almost a given. A deterioration in public finances seems likely but more money pumped into the rural economy could also boost consumption. 

The political schedule will guarantee bursts of volatility. The market crashed when it appeared the Gujarat election was heading for an upset result.  If there are similar surprises in store in Rajasthan, Madhya Pradesh, Chhatisgarh, etc, there could be sporadic outbreaks of panic. 

Balancing it all off, the bias could be towards bearishness. At the very least, several sharp corrections seem on the cards in 2018.