The bull ride

Retail exuberance keeps stock markets going

The stock market continues to rally, ignoring a 7.3 per cent fall in 2020-21 gross domestic product (GDP) and a cruel second wave, with high mortality and job losses. A few telling numbers are being cited about the surge that has lifted the Nifty 107 per cent from its nadir in late March 2020, when the first lockdown was announced. At over $3 trillion, the market capitalisation-to-GDP ratio is now well above 100 per cent. This is the first time since 2007 that market capitalisation has passed that level. The long-term average is 77 per cent. According to investing guru Warren Buffett, a high ratio is one sign of a frothy market ripe for correction. While First World nations have sustained high ratios for long periods, it is unusual for developing nations. China, for example, has a ratio of about 80 per cent.

This is partly a statistical anomaly caused by shrinkage of the denominator — GDP — coupled with the listing of many new companies in 2020-21, which raised market cap. However, even after allowing for those factors, it is still extremely high. Another interesting data point is that corporate profits for FY 2020-21 have hit a 10-year high at 2.63 per cent of GDP. Again, the shrinking denominator of GDP contributed. However, earnings did grow at an extraordinary pace in the second half of 2020-21. While the Nifty has risen 12 per cent between January and June 2021, the aggregate PE ratio dropped from a peak of 41-42x in mid-February (when Q3, 2020-21 results were still coming in) to current levels of 29-30 after the Q4 results. But it is a high valuation by historical standards and in comparison with other emerging markets. Revenues did not rise much in a year of lockdowns. But profitability shot up due to cost-cutting, lower interest rates, low commodity prices, and lower corporate tax. Part of the cost cutting was due to layoffs and work-from-home. As the economy normalises, these costs should rise again — indeed employee-related costs did rise in Q4 (January-March 2021). Global commodity prices are also up.

One interesting aspect has been the enthusiastic participation of retail investors, directly and via mutual funds. When institutional enthusiasm has flagged, retail has shored up valuations. In May 2021, for instance, foreign portfolio investors sold Rs 6,000 crore worth of shares and domestic institutions bought only worth Rs 2,000 crore. But the market rose 7.5 per cent on the back of retail buying. The huge retail exuberance looks anomalous, considering high unemployment and Reserve Bank of India’s household surveys, which show poor consumer confidence and low expectations. But low interest rates have induced investors to bet on equity, given poor returns from other assets.

Optimists will point to the earnings gains, and to estimates that FY 2021-22 will log high single-digit GDP growth despite the second wave. Low base effects will surely contribute to high year-on-year earnings growth through the first half of 2021-22. The pessimists will look at poor consumption data, high mortality rates, and a likelihood of GDP growth estimates being revised down. If smart institutional money is more conservatively deployed than retail, that’s also a red flag. Historically, corrections have been severe when India has hit a high market cap-to-GDP ratio and corporate profitability has also reverted to more normal levels. Investors, particularly retail, should not ignore fundamentals.