Equity market is a vague indicator of economic fundamentals in the short run. In the long-term, stock market has reasonable linkage with economic growth, corporate earnings and government policies. However, despite disappointment on growth front and below par company earnings over several quarters, equity market has been making new highs this year. A day after the government announced its mega recapitalisation package of Rs. 2.11 lakh crore for banks last Tuesday, benchmark indices ended at record highs. Continued bullish sentiment took the market to new closing peaks of 33, 266 on BSE Sensex and 10,364 for NSE Nifty on Monday.
Broad consensus among market players is that the benchmark indices will scale higher levels in coming months. A level of 10,600 on Nifty is not ruled out. However, if the linkage between equity market, economy and corporate earnings should ideally determine market’s performance over medium to long-term, then there are more reasons for this market to go down than rise. Certainly, 5.7 per cent quarterly growth (new GDP series) does not qualify for euphoria. There is no case for Sensex to trade at 33,000-plus level when corporate earnings are flat for last three years. GDP growth of around 6.5 per cent for the current fiscal also does not support historic highs.
Market operators and investors have ignored the fact that the rise in market is despite all the challenges the economy has faced. Often, financial markets need a reason to go up. But hope alone can’t be the reason for an unrelenting bull run when turnaround in economy is unlikely in the near future and growth in corporate earnings is expected to be patchy. It is safe to assume that Prime Minister Modi will fall well short of his many election promises. The common man certainly expects the elusive better days, and the financial market should expect even better performance on growth revival and policy front. But the market, instead of being cautious and watchful, has run well ahead of fundamentals during three-and-half years of the Modi government. As a result, there is distinct concern over valuations.
The distortion in fundamentals and valuations is visible in several indicators: earning per share (EPS), price-to-earning (PE) multiples and falling growth. But the market continues to be in overvalued zone. Equities began to rise in early 2014 when a NDA/BJP majority was a distinct possibility. At that time the NSE Nifty was at 6,000 points. Today it has crossed 10,000. During this period the earning per share for Nifty has grown by only 2 per cent, while the Nifty has appreciated more than 66 per cent!
Clearly, there is no co-relation between earnings and index. There are two reasons for market’s roll to new peaks: one, the Modi factor and two, political stability. However, in absence of a convincing turnaround in earnings, both reasons are not credible enough for bellwether indices to rally nearly 75 per cent since mid-2013.
Though Modi continues to be the darling of equity market – the stock market is a right-wing bastion – the government has not done exceedingly well on policy front to fuel an unrelenting one-way rally. Leave side sentiment and momentum, the market has been so illogical that it has ignored historical averages. At index level, the market is trading 22 times PE multiples currently, against the historical average of 16. The trailing PE of BSE midcaps is now at 34 times. In the past, market has traded at 20 PE multiples or more, but those were the days when the economy was growing between 8 and 9 per cent (old GDP series) and PE multiples of 20 were supported by EPS growth of 20 to 25 per cent.
So, why is the market turning a blind eye to overall subdued state of economy – muted growth, contracting industrial activity, struggling medium and small enterprise segment, fewer jobs etc – and weak corporate earning? Even if one accepts the argument that market is always forward looking and hence tends to price-in forward earnings projections to value stock prices, consensus earnings projections have often gone wrong for quite some time now. The misalignment with fundamentals can be explained by the flow of excess liquidity, particularly domestic, into equities. In the last one year, thanks to low interest rates on bank fixed deposits, domestic investors have pumped in Rs. 70,000 crore into stock market through mutual funds.
However, in sharp contrast, foreign institutional investors who have been aggressive buyers earlier have turned net sellers in recent months. For instance, in the last three months foreign participatory investors have sold stocks worth $3.4 billion. Still, the market has rallied to higher levels, thanks to local buying since January this year at $11 billion. Weak fundamentals and high valuations is obviously the prime concern for foreign investors, but surprisingly not for domestic investors who are buying aggressively. When risk-free rates have collapsed, earnings are stagnant and PE multiples are at historical highs, the question is: how long will the market sustain the distortion between fundamentals and valuations?
It is quite likely that in the near term, given oversupply of domestic liquidity, the market may remain in overvalued territory. But there are quite a few risks that could trigger a sharp or a meaningful correction. Earnings growth of companies is critical to sustain expensive valuations. As long as there is no visible turnaround in the much-delayed corporate profits, the risk-to-reward ratio will remain negative. For market to remain in stable zone, execution and implementation of policy reforms by the government is crucial. Revival in economic growth will be equally important.
The author is an independent senior journalist.
