Economic Survey sounds a note of caution on the high equity valuations

The Economic Survey 2018 sounded a note of caution on the high equity valuations and hasn’t ruled out a possibility of a correction. After a sharp 23 per cent rally this financial year, the benchmark Sensex is trading at 27 times its trailing 12-month earnings. The broader-market BSE Midcap and Smallcap indices, which have outperformed the benchmark in FY18, are trading at even higher valuations of 47 and 105 times, respectively.

“Sustaining these valuations will require future growth in the economy and earnings in line with current expectations, and require the portfolio re-allocation to be semi-permanent. Otherwise, the possibility of a correction in them cannot be ruled out,” the Survey said.

Domestic equities have risen sharply on expectations of strong corporate earnings. However, the earnings growth has been elusive so far, only to belie analysts’ expectations.

“Expectations of earnings growth are much higher in India. Indeed, it was such expectations that lie at the origin of the stock market boom. In early 2016-17, signs emerged that the long slide in the corporate profits-to-GDP ratio might finally be coming to an end. Investors reacted to this news with alacrity, bidding up share prices in anticipation of a recovery they hoped lay just ahead. Accordingly, the ratio of prices-to-current earnings rose sharply,” said the report.

The lackluster earnings trajectory has been largely on account of policy disruptions such as  implementation of the goods and services tax (GST) and demonetisation. The Street is expecting a turnaround in earnings.

“There is exuberance in broader market valuations, largely on account of earnings revival expectations. Therefore, if earnings disappoint or if there is a drop in incremental flows, we could see a sharp correction,” said Gautam Duggad, head of research, Motilal Oswal Institutional Equities. What has kept stock prices afloat despite lack of earnings momentum, is the availability of abundant liquidity — both globally and domestically.

According to the Survey, low interest rates, globally have resulted in a fall in the equity risk premium (ERP). Low ERPs have led to a shift in portfolio allocations from debt to equity.

“In sum, the Indian stock market surge is different from that in advanced economies in three ways: growth momentum, level and share of profits and, critically, the level of real interest rates. Low levels of the latter have been invoked to justify the high valuations in advanced economies. By that token, India’s valuations should be much lower,” the Survey said. “So, what appears to be driving India’s valuations are a fall in the ERP reflected in a massive portfolio re-allocation by savers towards equity in the wake of policy-induced reductions in the return on other assets.”.

In the domestic context, the portfolio re-allocation has taken place due to a fall in returns of traditional assets, such as gold and real estate. Also, demonetisation led to a spike in the financial savings, large part of it got channelised into the equity markets.

“Previously, stock prices had suffered because reporting requirements were higher on shares than purchases of other asset. But, the attack on illicit wealth has helped level the playing field,” the report pointed out.

Besides valuation concerns, the survey has also termed the rise in crude oil prices as a major risk for the macroeconomy. Crude oil has gained 25 per cent in the past one year and is currently trading close to $70 a barrel.

“Rising oil prices in the global markets put a lot of pressure on the Indian economy. Whenever the prices go up, the inflation shoots up and the fiscal deficit also increases. The current oil prices are looking relatively expensive, and in order to absorb the shock of rising oil prices, the government may have to do a balancing act by reducing excise duties, so that it doesn’t impact the inflation,” said Deven Choksey, managing director, KR Choksey Investment Managers.