Bull charge, for now

But debate over market valuations persists

Enthusiastic buying by domestic institutions and foreign institutional investors has driven India’s stock market capitalisation to a record $2 trillion and taken the equity indices to new highs. In terms of valuation, India is now the world’s most expensive equity market. The bears suspect the current valuations are unsustainable. But they are outnumbered by the bulls, who present a compelling case: Improving macro-economic fundamentals and continuing reforms are triggers for higher corporate earnings growth even as higher liquidity pushes up stock prices. Low inflation, a controlled fiscal deficit, low commodity prices, and a strong monsoon are cited as the other positives. In addition, there’s the introduction of the goods and services tax (GST) and an apparent willingness to tackle bad loans in public-sector banks. The bulls are also betting on political stability and many are assuming long-term political and policy continuity even beyond the 2019 general elections. Global growth is also expected to improve, despite geopolitical tensions and US policy uncertainty. Pessimists, however, claim valuations have run far ahead of projected earnings gains. While conceding that the economy is emerging from a prolonged slump, the bears say that it is not capable of sustaining the growth required to justify present valuations.

The fact is that the market mood has been optimistic since the Budget presentation in February 2016. The 50-company Nifty and the 30-company Sensex (all 30 Sensex companies are included in the Nifty) have gained 21 per cent in the past year. Midcaps and smallcaps have done even better. Many smaller stocks saw triple-digit gains as mutual funds and retail investors focused on relatively small fry. India is the world’s ninth-largest stock market and the largest Emerging Market after China. The Sensex is trading at a current price-earnings (PE) valuation of 22.9. The one-year forward earnings ratio is estimated at a PE of 18.2 for the Sensex. The Shanghai Composite is at a forward PE of 13.7 and even the high-valued US DJIA is at a PE of 17.5. The difference between the current PE of 23 and estimated Forward PE of 18.2 implies the Sensex’s earnings growth will accelerate to 25 per cent in 2017-18. This would be unusual historically but not unprecedented. The Sensex has grown at a compound annual rate of only 7 per cent since 2010 and at 10 per cent since 2001. But it did hit earnings growth rates of 25 per cent or more in FY05, FY06, FY07, and then in FY11. The optimists point out that the market cap-to-GDP ratio is below 1, with India’s GDP at about $2.3 trillion. At previous market peaks, such as 2007, the market cap has climbed to 1.5 times GDP. So there could be a substantial upside. 

If the sentiment stays at this pitch, the rally should continue. But there will be inevitable teething troubles with the GST and that could lead to a moderation of exuberance if it continues longer than expected. Apart from geopolitics, other possible triggers for selloffs include escalation of trouble on the Western border, or bovine-related socio-political tensions translating into widespread unrest. The tussle between the two viewpoints will be interesting. As of now, the bulls are clearly on the ascendant. But traders are known for their depressive tendencies. Big bear markets can develop with surprising speed when the mood changes.