There is a global consensus that the US Federal Reserve will raise interest rates for the first time in nine years this coming Wednesday. In anticipation, global markets have been volatile. The US markets have broken out of a long period of low volatility while trending slowly upwards. They have now been jumping like a kid on a trampoline for the last four months.
The Indian markets, meanwhile, are morose - almost comatose - in sharp contrast to the situation 18 months ago. On 16 May 2014 when the Bharatiya Janata Party-led coalition led by Narendra Modi romped home with a stunning victory, the market, already rising in expectation since February, went delirious. The Sensex hit a high of 25,376 on that day and went on to cross 30,000 in March 2015. Last Friday, the Sensex was at 24,930. In effect, collectively, stock prices of the top 30 companies of India have come back to the same level that they were 18 months ago.
The market euphoria over the prospects of the Indian economy under the Modi government may have ebbed in terms of price - but not in the spirit among investors. I have been reading the market forecasts and analyses of a few accomplished and thoughtful investors, and they still believe that "economic transformation takes time" and is "accompanied by short-term pain". Some, who are bearish, are nevertheless still positively inclined: their theory is that the current exasperating sluggishness of the Indian economy is partly because the Narendra Modi-led government is squeezing black economy out of real estate. This is "good economics" and we are likely to be handsomely rewarded if only we are a bit patient, they say.
Unfortunately, faith in politicians (suffering from multiple short-term compulsions) does not help in investing decisions. Stocks move on the basis of a complex interplay of multiple factors - some internal to the market (earnings growth, commodity prices, market structure, simpler and transparent regulations), and some external to the market (interest rates, inflation, currency, economic freedom). Till mid-October last year, there were no changes in any of these factors. It is worth noting that by the middle of October, the Sensex had recorded hardly any gains since the new government came to power. This was well before the government unimaginatively boxed itself into a corner by making the passing of a few Bills the be-all and end-all of "reforms".
This sluggishness in stock prices was because of a combination of no earnings growth and no meaningful steps to increase economic freedom. To me, programmes to change social behaviour with uncertain outcomes like Swachch Bharat being top priority, was also symbolic - but I was in a hopeless minority. Everyone was quite content cheerleading this and other government "schemes" and so I suspect they had no negative impact on the market.
The oil boost
Then, oil prices suffered a windfall decline in the six months between July 2014 and January 2015. Oil has fallen even further now, to almost the same level it was in November 2008, despite a 50 per cent fall in the value of the rupee since 2008. Partly because of this, from mid-October 2014, the Sensex went up sharply. After all, collapsing oil prices were certain to lead to the much-awaited economic recovery.
The assumption wasn't wrong. A lower oil price courses through the entire economy boosting growth, but the market hadn't reckoned with the big daddy: the state. The only entity to gain from the collapsing oil prices was the government (to sustain its wasteful expenses) - both directly and through oil companies, which are owned by the government. Hardly any benefit went directly to consumers and private companies.
After the second Budget of the Narendra Modi-led government, it was clear that the business climate (tax administration, licensing, big government) had not changed much. This was another tax-and-spend government, like the previous ones. The various social schemes with a dubious record of reaching beneficiaries were kept intact. Some were recycled and remarketed on a much larger scale. Time was spent on this, rather than increasing genuine economic freedom for businessmen to create jobs.
In short, neither of the two sets of factors - external and internal - is favourable. It is symptomatic that the Sensex peaked a few days after Budget day in 2015, and is down almost 20 per cent since. Meanwhile, there has been no earnings growth (the principal driver of the market) until the latest quarter ended September 2015. Foreign institutional investors are now on a selling spree and it has little to do with the upcoming Fed hike. They would have stayed put if Indian companies were on the growth path. That leads us to the core issue of market valuation. How is the Sensex valued after the recent decline?
The historical trend of the most popular measure of valuation, the 12-month trailing price-to-earnings ratio, gives us a clue - as long as one compares similar economic periods. My sense is that we are in a situation similar to 2011-13. The "policy paralysis" of 2012 has been replaced by the "legislative paralysis" of 2015. Interest rates are lower but the banks are in a bigger mess than before. Companies with some competitive advantage in the export market are doing well. Worryingly, despite significant weakness of the rupee, TCS, a bellwether stock for the software sector, is at an 18-month low. Market valuation is high. The average Sensex PE in 2011-13 was about 15 per cent lower than the current PE. When market valuation is high, there is a risk of decline in both valuation and profits. My sense is that profits cannot go down sharply from the current level, especially since the Sensex has a better quality of stocks now. Valuation can still contract quite significantly. A baby bear market said hello to us in May. Since then, it is no longer cuddly. It is young and starting to growl.