Indian stock market indices are scaling new highs every day. The BSE Sensex and the National Stock Exchange’s Nifty 50 hit 38,076.23 points and 11,495.20 points, respectively, for the first time ever, on Thursday. While it may seem that the bulls are ruling Dalal Street, investors should look beyond market levels. Essentially, the question to be asked is: is the rally due to a rise in earnings, or is it because valuations have expanded?
The chart alongside shows that the recent rally has been accompanied by a sharp rise in valuations. For instance, the one-year forward price-earnings (P-E) multiple for the Nifty 50 index has gone up from 16.4 in April to 18.4 now.
Similarly, the P-E multiple for the Sensex has gone up from around 17.2 in early July to 18.8 now. This rally, in short, has been driven by a rise in valuations.
On the other hand, as this column had pointed out, Bloomberg’s consensus EPS (earnings per share) estimates for the Nifty 50 index have been falling. It is well-known that it’s a very narrow market with the rally being led by a few heavyweights.
The reason is high domestic liquidity, particularly flows from systematic investment plans. It’s also interesting that in recent times, foreign portfolio investors too have returned to Indian markets, perhaps owing to a stable rupee and lower crude oil prices. Foreign institutional investors are net buyers of Indian shares so far in August. They were net buyers in July as well.
Simply put, earnings have to catch up for the rally to sustain. June quarter earnings have benefited from a low base last year. Earnings growth will have to be robust to justify the optimism shown by the rising P-E multiples.