Too much, too fast

Tepid earnings not in sync with stock prices, valuations

The stock market rally has surprised analysts and fund managers in more ways than one. Inflows from global and domestic investors continue to keep the momentum going and prices high, and the rise of mid- and small-cap stocks has been spectacular; yet, many investors in equity and mutual funds find their portfolios not doing as well as the markets seem to be doing. The biggest puzzle for analysts and fund managers is that the tepid corporate earnings in the March 2017 quarter do not seem to be in sync with current prices and valuations. This calendar, the Sensex has rallied 17.4 per cent, the BSE 500 is up 21 per cent, and the BSE Midcap index has gained 23.6 per cent, as the stock markets shrugged off the demonetisation blues. At current levels, valuations are not cheap. The Sensex is trading at a trailing 12-month price-earnings multiple of 23, at a premium of nearly 24 per cent to the 10-year average. Going beyond the large-cap stocks, the BSE 500 index, which has a larger universe of companies compared to the Sensex and Nifty, is trading at a P/E of 25, which is 36 per cent more than its 10-year average, while the BSE Midcap index at 32 times is trading at a 56 per cent premium.

No wonder then that market observers are concerned. UBS has downgraded India to neutral valuations as it is no longer as attractive as it was in February, when the foreign brokerage upgraded the Indian markets to overweight when the post-demonetisation trends were beginning to improve. On the fourth-quarter results, many brokerages have said that the underlying drivers for most sectors continue to be weak, which has led to further earnings downgrades. Another report goes further and says the current 14 per cent consensus growth expectation for FY18 might come down to 6-8 per cent as the year progresses. For the past few years, the earnings growth forecast by analysts was steadily downgraded from what it was at the beginning of the year. In the FY14-FY17 period, the Nifty companies’ combined earnings per share was flat. The question on everyone’s mind now is whether it will be different this year.

The flow of foreign portfolio investments slowed from over Rs 44,000 crore in February and March to Rs 6,300 crore since April, but mutual funds came in with Rs 22,000 crore of investments. Domestic investors have lapped up mutual funds, exceeding investments of over Rs 83,000 crore in 2017 so far, fuelling the liquidity-driven rally. However, mutual fund managers too are not buying into the rally with conviction. The macro picture is looking better for sure but an external global shock, rising global bond yields, and withdrawals in foreign flows would be negative. At the micro level, the worst may not be over for public sector banks, while high-profit, high-margin, and high-valuation industries such as software, pharmaceuticals, and telecom are facing structural problems or intense competition, which could slow earnings growth. Even if current market levels are maintained, investors should brace themselves for a correction as the market seems to have gone up too much, too fast, and the levers of earnings growth do not appear well-oiled.