Beware of highs

Earnings growth may not support stock prices

India’s stock markets soared to new highs last week, shrugging off worries around a possible debt default in China’s real estate behemoth, Evergrande. The Sensex crossed 60,000 and the Nifty touched nearly 18,000. However, some caution is in order as the positive factors, which coincided in sustaining this rally, may not remain in play much longer. Earnings growth rates may fall, and the fear of a Chinese real estate implosion remains. Hence, it may be appropriate to temper optimism. In the past 12 months, the Sensex has returned over 60 per cent, and the Nifty slightly more. But these returns have been beaten hollow by smaller stocks, with the Nifty Midcaps 400 gaining 83 per cent in the past 12 months and the Nifty small caps 250 increasing 92 per cent. The initial public offering (IPO) market has witnessed frenetic activity and delivered great returns too.

Every class of investors has participated in the rally and benefited. Foreign portfolio investors (FPIs) have bought Rs 64,655 crore of equity in calendar 2021, while domestic institutions (ex-mutual funds) have pumped in Rs 22,635 crore. Equity funds have seen assets under management rise 35 per cent in value since December 2020. Fundamentally, despite rising share prices, valuations have fallen from a peak of PE 41 plus in February 2021 to current levels of 27 plus. This is because profits grew by extraordinary amounts in Q4 2020-21 and Q1 2021-22 due to the low base of the corresponding quarters. That base effect will wear off in the second half of 2021-22, raising the prospects of a decline in the earnings growth rate. Also, valuations are high by historical standards. Part of the enthusiasm is due to the fall in interest rates through much of this period. Firms have deleveraged considerably, paying down debt and refinancing debt is cheaper in this benign rate-cycle. The Reserve Bank of India is unlikely to cut rates again, given higher inflation. At best, investors can hope rates stabilising at current levels. Consumption is still weak, with key sectors like automobiles and fast-moving consumer goods running at well below capacity, and banking credit seeing anaemic growth. So, revenue growth may also disappoint.
 

Two global factors could retard further extraordinary gains. One is that the US Federal Reserve is starting to consider a taper of its asset purchase programme in early 2022. This could lead to caution from FPIs. The other, and more serious worry, is the possible bursting of China’s real estate bubble. Evergrande is the largest realtor at risk with over $300 billion in debt and a cash crunch that has stalled many projects. But other highly leveraged Chinese realtors are also struggling, with an aggregated debt of over $1 trillion for the top four. If China’s housing boom does go bust, there will be a negative impact on commodity markets, and on overall global growth. The attitude to Indian stocks is also looking speculative. Until recently, the stock market was driven by gains across commodity sectors, mainly industrial metals. It is now being pushed up by speculative positions across real estate, with the realty sector index jumping over 30 per cent in the last month alone. The housing market doesn’t seem to justify such enthusiasm. While the consensus suggests the economic recovery will continue, the huge gains in profitability will not. Investors should be prepared for disappointments on that front, which could mean price corrections.