During the past four years, equity market valuations have shifted meaningfully higher. The average trailing PE for the Nifty 50 during this time as published by NSE is 22.96 times. Incidentally, the P/E rose above 20 times just three days after Prime Minister Narendra Modi came to office on May 19, 2014. The valuation low under the Modi regime for PEs was 18.65, and an average PE of 22.96. By way of comparison, the valuation low during the prior years 2010 to May 2014 was 15.23 and average P/E of 19.52, a meaningful difference in both cases of 3.5 points. The reasons for these extraordinarily high P/Es were demographic drivers for growth, domestic financialisation, and dominant equity performance. Valuations at the index level have remained elevated.
There is no alternative
Alternative asset class returns have disappointed. Gold at the start of the Modi regime was 1294. Now it is 1312, yielding an annualised return of 0.4% a year. Gold in rupee term has done better, earning 4% a year, but even fixed deposits have beaten gold. Fixed income is somewhat better.
The CRISIL bond benchmark has returned 8% a year since 2014, but returns have been progressively lower as we have moved into 2017 and 2018. Real estate returns are mediocre as well, with residential real estate investors stuck with inventory and bleeding, although commercial realty seems to hold promise.
Therefore, one reason equities remain elevated is there are limited attractive investment alternatives and investors are not attracted by the 4-8% return that alternative asset classes offer today. Rather, investors are willingly taking the call that they can beat alternative asset class returns via equities.
What if equities were bought at the peak in 2015?
We make the extreme assumption that investors bought at the top in March 2015. Clearly, they suffered immediate remorse with the ensuing correction. If they held on, however, they bagged a blended 11.1% return—Nifty 50 and Midcap—from equities, far in excess of alternative asset classes.
Using the CNX 500 as our universe, and the assumption that an investor purchased at the market top in March 2015, the average CAGR return for CNX 500 stocks is 17.1%. Some may argue that PEs weren’t inflated in 2015, but that would be incorrect.
The P/E of the market on March 4, 2015 was 24.1 times, very elevated. The 17.1% CAGR would be much higher if the investor simply ignored PSUs and telecom. And 63% of equities in the CNX 500 delivered returns above 8.0%, and 56% of equities delivered returns above 12%.
Macros are mixed
The macro outlook has weakened, with the continued rise in crude oil upsetting the fiscal situation, pushing the rupee higher and interest rates higher. But macro conditions can change on a dime. On the other hand, auto sales and credit growth remain strong, demonstrating a healthy consumer. Rural appears to be on the path to recovery. Strong top line growth and operating earnings growth by companies is another positive. PMI data shows that Services and Manufacturing remains in growth mode. As we have stated earlier, equities can do well in periods with gradually rising crude, to a point. Equity valuations are likely to stay high, at least while euphoria around the current regime holds. For risk averse investors, the adage of loss prevention first holds. For investors with the unwillingness to bear volatility, capital protected strategies are appropriate. These strategies will generate alpha on sell-offs, and peace of mind.
Sunil Sharma is chief investment officer & executive director, Sanctum Wealth Management. Edited excerpts from Investment Strategy