By Hemant Manuj
The key market indices, S&P BSE Sensex and NSE Nifty, have closed at their lifetime highs. The Sensex and Nifty are at a breathing distance from 40,000 and 12,000, respectively. How long can they keep rising? The market participants have been categorised into three areas:
* Those who are bullish and see the event as a confirmation of a strong expected growth in corporate earnings. These are mostly from the sell side of the market. While brokers are commonly known as sell-side participants, many long-only portfolio managers also feel necessary to act bullish as they need to grow their portfolio size.
* Those that raise a clear red flag, citing bearish signals. These are in minority and comprise of a few individual analysts or unaffiliated research agencies.
* Those that do not have a clear opinion of their own and follow the advice of one of the above categories of analysts. These are mostly retail or non-professional investors, who are not equipped to understand or analyse market behaviour on their own.
I belong to the second category and wish to highlight a few facts here in support of my thesis that that the market is overheated.
High P/E ratio: The Sensex is quoting at a price-earnings ratio (P/E) of 28.34x. The accompanying chart plots the Sensex (LHS) and the P/E of Sensex companies (RHS, thick plotted series). The P/E ratio at each point has been computed, based on the trailing 12 months’ earnings of Sensex companies. The chart plots the entire journey of the Sensex since the opening of the Indian equity market to foreign investors in June 1992, which was a regime shift for the Indian market.
When the Indian equity market was opened to the foreign portfolio investors (FPIs), it led to a sharp rise in P/E, followed by equally sharp correction. It took a few years for the FPI regime to settle. My analysis is focused on the period after 1995. It may be noted that P/E of the Sensex (RHS of chart) has exceeded 26x just three times in the last 24 years.
April 2000: This was followed by the dotcom burst and the Sensex fell by 40% after that date.
December 2007: This was followed by the global financial crisis (GFC) and the Sensex fell by 56% after that date.
March 2019: Will history repeat itself?
The fact that P/Es here are based on historical earnings, and not forward earnings, should not affect our conclusions. P/Es have been computed consistently on the same basis for the entire period. Also, forward P/E is merely a derivation of historical P/E, and any conclusion can be suitably adjusted based on expectations of forward earnings. The dividend yield (not plotted in chart) had dropped to under 1% in April 2000 and December 2007. It is currently at 1.15%.
The economy and earnings: The forecast for the global economy is not positive, to put it mildly. The IMF has, twice within the last few months, cut its forecast of global annual GDP growth rate for 2019 and 2020 to 3.3% and 3.6%, respectively. They may not yet be done with the cuts. All major central banks have signalled an accommodative stance for 2019, at the least.
Indian GDP growth rate has slowed down in the last two quarters, and the government has revised its estimated figure for FY19 to 7%. The fiscal deficit, adjusted for the government’s obligations pushed to FY20, should be close to 3.8%. Private investment is not showing any signs of picking up. While exports have picked up, it will be tested against the slowing global economic growth. Oil prices are again moving upward. Food inflation has been kept under control, primarily by keeping agriculture output prices low, but this may not be sustainable in the light of the unrest amongst farmers. On the whole, the economic picture looks hardly enthusing.
Corporate profitability has been subdued for several years. Market analysts are, once again, hoping profit will grow in high teens in FY20. But it is doubtful. The firms lack the pricing power in view of lacklustre growth in jobs and wages. Discretionary consumption expenditure in cars and motorcycles is sluggish. Industrial capacity utilisation has shown a marginal upward trend, but not enough to make a positive impact on private investments in capacity expansion.
The IBC was, and still is, a singular glimmer of hope in unlocking the capital of banks. But the delay in the process of resolution of several large cases has been a disappointment. Banks are reluctant to fully adopt the IBC process and prefer bilateral negotiations with many large defaulting borrowers. Also, the losses of the power sector are building up, threatening to build up NPAs of banks.
So, why is the valuation high? One reason is central banks globally are back to creating more liquidity, which is flowing into financial assets rather than real assets. This has led to a sharp rise in FPI investments in emerging markets, including India, and helped sustain the dizzy valuation.
We also come up with appealing justifications for high valuations. We hope for a sharp growth in corporate earnings and focus on a few statistics on the economic landscape, reflecting the brighter side of the same. We all suffer from a ‘confirmation bias’ and tend to selectively see the picture and justify our beliefs. The hope for a resurgence in the economy and politics, led by a second term by Modi, is also a self-fulfilling factor in keeping the valuation high.
So, what to expect? In the stock market parlance, a clichéd and often abused phrase is, “This time, it’s different!” However, we need to look at the real picture. It is almost impossible to predict the time of burst of a market bubble (extreme over-valuation). But history has shown that a bubble does eventually burst, in spite of several voices justifying high valuations. A large section of institutional investors had continued to maintain a bullish view in 2000 and 2008, till the bubble burst in those years.
The risk of being wrong is doubly high this time. Even as high valuation indicates high risk of a meltdown, the correction is likely to be tougher this time around. Consider this: The real interest rates were, in the past, sharply cut by central banks, after the meltdown in equity markets. This time, central banks in Europe, Japan and the US do not enjoy any significant bandwidth to reduce their nominal, or real, rates.
The high valuations of the Sensex and Nifty are not unsustainable, unless backed by a sharp rise in corporate earnings. That’s a hope, balanced against an array of risks. A sharp correction is more likely than any significant rise from here. As Benjamin Graham would say, a market is a voting machine in the short term, but a weighing machine in the long term. Investors should make their choices judiciously at this stage.