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Markets on stretched valuation, but exuberance may still enlarge

Share Written By
Mr.Dhananjay Sinha

Head of Research, Economist & Strategist

04 May 2017

The disquiet over stock market valuations is on the rise with Indian benchmark indices scaling all time highs while patchy corporate performances fail to support the valuations. Despite some pick up in earnings in the second half of FY17, full year aggregate earnings for both Nifty and Sensex are likely to end up being flat. These bellwether indices have rallied nearly 75% since mid-2013 despite stagnant profits over the past three years and this is a cause of concern as the trailing price to earnings (PE) ratio has risen to a high of 22x.

Mid-cap stocks have seen an even stronger upsurge, rising 180% with the trailing PE of the BSE Mid-cap index now at 34x, again not supported by a commensurate improvement in profit performance. Expanding valuation for mid and small cap space has had a capillary action by pulling in flows form investors, thereby reinforcing the stretched valuation.

The impression that the market is possibly distorted in context of its fundamentals reflects in multiple indicators. The zero earnings growth for Nifty companies since FY14 is worse than the average 4.5% growth since FY08. But historically (prior to 2010), multiples of 20-22x were supported by consistent EPS growth of over 25%. The current trailing PE multiple of 22x is nearly 33% higher than the long term average of 16.5x. Secondly, ROA of Nifty companies has declined consistently to 2.5% compared to a peak of 6.5% in 2008 when valuations were at 22x. Thirdly, assuming India’s real GDP growth at around 5% on the earlier 2004-2005 series corresponding to 7% as per the new series (long term series for the new series 2012-13 is unavailable) the current PEG stands at 4.4x which is even higher than 3.8x during the dot com bubble of 2000-2001 and an average of 1.8x during the high growth periods of 2004-2008 when GDP growth averaged at 9% and corporate earnings were compounding at 25%.

The contention is why should markets sustain in a perpetual overvalued zone? The common logic is that markets are forward looking; hence the role of forward consensus earnings projections is critical. Currently, one-year forward consensus earnings growth for Nifty companies is 25% and with this, one-year forward PE at 18x looks somewhat reasonable. However, we cite that consensus earnings projections have had a dubious track-record as over the past nine years, virtually for each year, consensus earnings growth for Nifty started off at 15-20% but ended up being significantly downgraded. Thus the actual earnings CAGR has been modest at 4.5% since FY08. Clearly, there has been no learning from the past and perversely, it appears that earnings projections have been catching up with stock prices. The other aspect worth acknowledging is that India’s robust GDP print of 7-7.5% as per the latest series is starkly in contrast with weak corporate earnings performance in recent years.

The answer to market being in a prolonged overvalued zone probably lies in three distinct factors. One, central banks, led by the US Fed, have pumping up asset prices by actively depressing risk free rates and market volatility to compensate for lack of earnings growth. The collateral surge in flows into emerging markets, including India, also resulted in asset price misalignment with fundamentals. Second, the expectation of earnings growth is kept alive by consensus forecast. And three, in the Indian perspective, domestic flows of retail investors into mid-cap stocks and funds have sustained over the past three years.

Our assessment of the global scenario suggests that the problem of overvaluation is prevalent across most global equity markets, both emerging and developed. For instance, EPS of world MSEI index has contracted at an annual rate of 1% in the last six years while the index PE has expanded by 45%. Likewise with an annual contraction in EPS of 1% for developed economy MSEI the PE multiple has expanded by 40% and for EMs MSEI EPS has contracted by 6.5% annually even as the PE multiple has expanded by 20%. US S&P 500 shiller cyclically adjusted PE (CAPE) at 29.38x is 75% higher than the average since 1871 and pre-2008 crisis level of 27.5x. 

This precarious balance between valuation, earnings growth and risk free rate is critical for the financial markets. The point is that all of these variables are displaying crucial attributes - risk free rate at historical lows, multiples at historical highs, and earning remaining stagnant.

But this benevolence is unlikely to sustain for long as recent developments indicate bottoming out of the risk free rates with Fed rate normalization now entrenched; the US Federal Reserve preparing to taper its bloated USD 4.5tn balance sheet and decline in EM’s surpluses are resulting in reduced official demand for US treasuries. Importantly, global portfolio flows into EMs have become less consistent since the end of US quantitative easing in 2014.

Sustenance of market exuberance is pivoted on ability of the central banks, especially the US Fed, to normalize the overly accommodative monetary policies without letting the risk free rate inch up faster than earnings growth. The good news is that earnings appear to have bottomed out somewhere in 2014-15 along with revival in commodity prices and improved momentum in major developed economies. Within the EM space, consensus estimates expect earnings revival led by China, Korea and Technology sector. Russia has demonstrated a comeback in earnings following the 2014 shock. In an ideal world, a goldilocks scenario of growth revival, moderate inflation and gradual rate normalization is essential for the markets where valuations are already much stretched.

But things can become tricky. For one, a faster rise in inflation due to either rise in commodity prices or sudden overheating can invite swifter rate hikes by the Fed, thereby triggering a meaningful correction in market valuation. Second, the combination of fiscal expansion and trade protectionism can further constrict global saving surpluses in the EMs resulting in higher rates and inflation. And three, the risk of earnings recovery failing to sustain beyond the near term.

Clearly, while concerns on valuation are real, absence of immediate normalization trigger can bate the market into enlarging the current exuberance even further.

From India stand point, so long as the global normalization trigger remains at bay, Indian markets will likely see continued investor interest getting relayed into areas that reflect valuation gaps. India appears to be heading into an upturn on the back of growth recovery in advanced economies, fiscal expansion by state & central governments with larger focus on entitlement schemes focused on rural and agri sector stimulus, better retail demand and normalization of the demonetization impact over the coming quarters. This reflationary pull should sustain investor interest in sector like consumption, retail lending, rural themes and material space.  

The risk from India’s stand point is that the requisite adjustments for a sustainable growth recovery are still not in place. For instance, the banking sector has still not acquired the counter-cyclical buffer to support growth. India’s saving rate has still not picked up despite earlier decline in commodity prices. Higher pace of retail lending and consumption and weak compensation growth indicate decline in structural portion of household savings. Productivity of capital is still sub-optimal for private investments to revive. And inducement of fiscal stimulus focused on various entitlement schemes ahead of private sector growth indicate shorter fiscal multiplier effect compared to earlier periods.