The valuation dilemma

A lot depends on the corporate earnings season

The BSE Sensitive Index (Sensex) on Tuesday posted its biggest single-day fall this calendar year, but that was due to specific government action that affected two of the biggest index heavyweights. Overall, the stock market has been in a euphoric mood for quite some time, hitting new highs driven by a tidal wave of liquidity. This is part of a global bull run, as 26 of the world’s 30 largest stock markets have been trading near their respective annual or historic highs. There have been inflows from every quarter — global fund managers are still upbeat about India despite higher valuations and say it is one of the strongest structural stories among emerging markets, as a result of which foreign portfolio investors have pumped in over Rs 70,000 crore into Indian stocks. While domestic institutions have contributed over Rs 45,000 crore, retail investors have also participated in a major way, both directly and via the fund route. Assets under management of equity funds have swelled by Rs 1.4 lakh crore since June 2016.

 

Most observers agree that the markets are overvalued and perhaps even in bubble territory, given the lukewarm performance of many sectors. The Nifty is trading at a current price-to-earnings, or P/E, ratio of 25, while the Nifty Free Float Midcap 100 is trading at an incredibly high P/E of 32. The Nifty has rarely hit these levels while mid-caps are at historically high valuations. Yet, earnings growth remains in the single digits for the broad market and the bad loans crisis is far from resolved, with many corporates struggling to service debt. The disruption caused by demonetisation has not yet worked its way out of the system and that has led to job losses and affected consumption. The goods and services tax (GST) is being hailed as a game changer, but it will also cause some short-term uncertainty. There are multiple linkages between the informal and formal economy and the GST will force an inevitable reworking of those value chains. That will take some time and earnings growth cannot stabilise until the re-forging of value chains is complete.

 

So why is the stock market euphoric? Ironically this is partly because the economy is not booming — other avenues of investment do not look as attractive. The investment cycle is in the doldrums with bank credit disbursal limping at 25-year low, real estate has not recovered from demonetisation, gold is in a bear market and falling interest rates have led to reduced returns on fixed deposits. The system is flush with money that is being deployed in the stock market in the absence of attractive returns from other avenues. In addition, the inflation rate is falling and more interest rate cuts are expected, pumping even more liquidity into the market. So investors are expecting quick returns. There are also optimists who point to expectations that there will be positive effects from several reforms such as the GST and the Real Estate (Regulation and Development) Act. But the market has been running higher and higher on such hopes for a long time. Eventually earnings must catch up if these high valuations are to be justified. Hopes are riding on this results season, it could be make-or-break for market sentiment.