Every business tries to reduce costs and increase profits. In the investment business, falling share prices equal lower costs, while rising earnings equal rising profits. So, the ideal situation for a long-term investor is one where share prices fall, while earnings grow. Even if earnings are stable and share prices fall, things are favourable since valuations are reduced, while profits are not. So, a rational long-term investor should be happy if share prices fall, provided earnings are not also falling. But, sentiment usually responds only to price moves.
Share prices have risen considerably since the Bharatiya Janata Party (BJP) took charge of the central government in May 2014. We might now see a situation where prices fall over the next year or an even longer period. If a sustained downturn does occur, it is very likely to also cause a downturn in sentiment.
There are several reasons why prices could fall. Indeed, the stock market has already corrected by a little over 10 per cent since March, when it hit all-time highs. There were unrealistic expectations of the new government. It had a parliamentary majority. Many campaign promises were made about "good times". In practice, the BJP has not been able to deliver on the bulk of those promises. There has been no tax reform, no labour reform at the Centre and land acquisition is still a big issue. Multiple projects remain stalled. Red tape remains pervasive. It is 17 months since the new government was installed and the politically savvy will understand that serious reform must be implemented by the end of 2016-17. Else, it is likely to be shelved until the 2019 general elections. If reforms are attempted later than that, there could be a negative vote in 2019. Radical changes like a goods and services tax or politically sensitive moves like labour reform or land acquisition must be given at least two financial years to settle before the benefits become apparent.
The BJP needs traction in the Rajya Sabha. A string of important assembly elections begin with Bihar, followed by elections in UP and West Bengal in 2016. Good performances in those would gain it that traction. The BJP holds some 104 out of 120 Lok Sabha seats in UP and Bihar. It is unlikely to take an equivalent number of assembly segments. But, it might do well enough to change RS numbers in its favour and there is hope on that front. However, the timing will be touch and go.
Meanwhile, the global situation has deteriorated. Global growth expectations have been pared. Trade has stagnated, with demand weak in almost every continent. India has been hit by this -- exports have been persistently weak.
Japan is heading into another bout of deflation. China is seeing an ongoing growth slowdown, coupled to the bursting of a valuation bubble. Europe is struggling to stay afloat. Other large emerging economies like Brazil, Indonesia, South Africa, Russia, etc, are struggling to contain problems. China has devalued and other currency devaluations are likely. America is the only major economy which appears to be in good shape.
Hence, global investors are being cautious. Despite being the fastest growing emerging market, India has seen some pullouts of foreign portfolio money. This is one major reason why stock prices might slide lower, regardless of what happens to earnings. Most global agencies and investors have downgraded earlier assessments of India's growth rates. The Reserve Bank (RBI) has also downgraded, in its recent monetary policy statement, where it pointed to specific areas of concerns (some of which are mentioned above).
Under such circumstances, investors become pessimistic. India's genuine problems are now being highlighted in analyst reports, rather than the positive aspects of the current situation such as low inflation and a rising rank on the Global Competitive Index.
The markets are responding and reconfiguring expectations. Corporate earnings have stagnated over the past three quarters and nobody seems to really believe the new series of Gross Domestic Product numbers. However, while growth is slower than the government would like to acknowledge, there is also consensus that there has been a slow recovery.
This means we might see a situation where prices travel down quite a distance, even as corporate earnings stabilise and grow, albeit slowly. RBI has considerably reduced policy rates in the past 10 months. At some stage, that will transmit through the commercial system, making high valuations more sustainable and boosting credit offtake.
This is a near-ideal situation for long-term investors. Even if reforms don't occur, there will be some growth. If prices do slide for an extended period, the lower valuations will mean better long-term returns.
