Pricing in hope

A reality check on the stock market rally

Indian equities have delivered a return of almost 50 per cent in the past 12 months. The Sensex has delivered higher returns over a 12-month period only twice in the past - in 2003 and in 2009. The latest turnaround is stupendous considering that, just about a year ago, the economy was battling rupee depreciation and stock markets were in reverse gear due to fears of capital flight. Most businesses and investors believe India is heading back to high growth - and high corporate earnings growth. This has led to a re-rating of stocks across sectors, with the expectation that future earnings growth will retrospectively justify high valuations. Corporate earnings and GDP growth for the first quarter of 2014-15 accelerated over the previous year, which appeared to justify a bullish outlook.

But look a little closer. Yes, the combined net profit of around 1,700 top listed companies (excluding petroleum & financial stocks) was up 35.3 per cent in the first quarter of 2014-15 over the same period last year - a sharp acceleration from 26.6 per cent year-on-year growth in the fourth quarter of the last financial year. But profit growth fell to 10.6 per cent if export- and foreign exchange-dependent sectors such as information technology (IT), pharma and automobiles are excluded. And the sectors that should have been at the forefront of a growth revival - construction, infrastructure and capital goods - continued their poor run, with a decline in revenue and profit. GDP growth was the highest in 9 quarters; but it was driven by exports, agriculture, higher electricity generation and government expenditure. An excise duty cut in the interim Budget, and continued in the full Budget presented in July, acted as a fiscal stimulus and aided consumer demand, visible in the finances of automakers and consumer goods companies. It's tough to sustain this cycle in the absence of higher investment demand, and given the need to reduce the fiscal deficit.

That Dalal Street doesn't care, however, is visible from the performance of medium- and small-cap stocks. While the Sensex is currently trading at around 19 times the combined net profit of its constituent stocks in the last 12 months, the corresponding ratios for the BSE Mid and Small-cap index are 23.1 and 29.5, respectively. Just like in 2007, enthusiastic domestic retail investors are mostly investing in second and third tier stocks. In contrast, foreign and large institutional investors are back to investing in top defensive stocks - the IT, pharma, and consumer-goods majors, as well as select private sector banks. So the rally in cyclical and rate-sensitive stocks seems to be fizzling out. A similar sector rotation happened in late 2011 and 2012 in the run-up to the sell-off in the first half of 2013.

Clearly, too much good news has been priced in at the moment. Even a small failure to live up to the high expectations could lead to a downward adjustment - leaving domestic retail investors once again holding the baby.