Street signs for 2021

Sharp earnings revival will ease valuations

One of the paradoxes of 2020 has been the global divergence between economic fundamentals and stock market returns. Growth in every major global economy has taken a hit due to the pandemic. But every major stock market has yielded positive returns. Since stock markets are forward-focused mechanisms, this implies expectations of a strong rebound in growth. Are markets likely to continue running up through 2021? Expectations do seem inclined in that direction. India has been among the worst performers of 2020 in terms of economic growth. Yet, the Nifty has risen 14.6 per cent since January and it has rebounded an incredible 86 per cent from its low in late March 2020.

The performance is driven by several factors. One is a surge in from foreign portfolio investors (FPIs), which have pumped in about Rs 1.7 trillion in Indian shares since January 2020. Another is continued support from the retail investor, directly and via the equity mutual fund route. Equity mutual funds have seen positive inflows and small-caps, which are traded more regularly by individuals than by institutions, have also done well. An underlying reason for support to risky assets may be the collapse of debt returns. The central bank has, with good reason, opted to hold policy rates and ensure positive liquidity to shore up a weak economy. But as inflation rates have risen, return from debt has gone negative. Domestic investors have moved out of debt, and so have FPIs, which sold Rs 1.04 trillion worth of bonds since January.

Valuations present a conundrum. The first quarter (April-June 2020) was a washout, with companies reporting losses, or drastic earning contractions.. The second quarter (July-September 2020) saw strong year-on-year profit expansion allied to marginal revenue contraction, although this came on a low base since the corresponding quarter of 2019-20 (July-September 2019) was weak. Statistical anomalies arise due to base effects, when common measures such as the price-earnings (PE) ratio are applied. The Nifty earnings dropped by 21 per cent in the first quarter of 2020-21, compared to 2019-20. Then there was a recovery of about 6 per cent in the second quarter. The PE ratio has risen to the current value of 38, as prices have since surged to record highs.

Looking at market performance through a broader lens, the Nifty’s earnings contracted by over 18 per cent in the first half of 2020, compared to earnings at end 2019-20. The low-base effect will continue to boost earnings growth until June 2021, at the least. Thus, it is likely that, even if the bull-run continues, valuations will rationalise further through the next few months. A return to pre-Covid levels of activity would, in itself, imply a bounce of over 21 per cent in earnings, and investor-expectations do target that degree of recovery by end-2021-22. Even though a PE ratio of 38-plus looks high, a sharp bounce in earnings is more or less guaranteed in the first six months of 2021-22. 

The market is “front-loading” those anticipated gains. A lot of hope is riding on the Budget in the form of policy support for various sectors. If the Reserve Bank of India maintains its easy money stance and the Budget is perceived to deliver in terms of policy support, investors will continue to back equity. Any disappointments could, however, lead to a very big selloff.