 "Where are Nifty stocks headed?")
The website, Capital Mind, recently ran a series of numbers centred on earnings growth and price-to-earning (P/E) ratios. The contention: the uptrend in the Indian market was irrational. The numbers, based on National Stock Exchange (NSE) data, are indeed hard to understand or justify.
In fact, the numbers are shocking. The Nifty has a P/E ratio of 23.3 and an earnings growth of one per cent year-on-year (y-o-y), an improvement after a few quarters of negative earnings per share (EPS) growth. The Nifty Next 50 has a P/E of 27 and EPS has shrunk at minus 12 per cent y-o-y. The Nifty Mid-caps 100 has a P/E of 33 and an EPS "growth" rate of minus 23.5 per cent y-o-y. The broad Nifty 500 has a P/E of 26.6 and an EPS growth rate of minus 3.7 per cent.
Clearly, EPS growth has been abysmal and the poor performance of the Nifty 500 shows the recession is widespread. The lack of growth has also been ignored by investors who have bid stocks up. So, the valuations seem inflated as well.
This is bubble territory. It is being sustained by several factors. One is very high liquidity, coupled with the promise of even higher future liquidity. That's a global phenomenon. Another related factor is low interest rates and the promise of lower interest rates. Interest rates are at historic lows and in negative territory in several regions. Money supply has also been pumped up by central bank action, with several rounds of Quantitative Easing. The Brexit development makes it likely that there's more of the same loose money policies in store.
India could also gain on the "one-eyed king" principle. Though the Indian corporate numbers are bad, they are perhaps a little better than elsewhere. Most cynics would reckon the poor EPS growth casts doubts on the official estimate of 7.6 per cent gross domestic product (GDP) growth. But perhaps, some foreign portfolio investors believe that the GDP growth will translate into higher EPS. At any rate, strong Foreign Portfolio Investor inflows (and FPIs switching out of rupee debt into equity) have buoyed up prices.
Is this combination of low or negative EPS growth and high valuations sustainable? It actually, might for an indefinite period. The global regime of negative and near-zero policy rates and tiny bond yields has led to massive risk appetite. In fact, we have never seen negative policy rates for such a sustained period over such large regions. And, negative rates make a mockery of the standard comparative valuation methods. In theory, an investor looks at the risk-free yield from debt and seeks a higher return from equity. Many investors invert the P/E ratio and consider Earnings divided by Price as the equivalent of the yield from a debt instrument. By that reckoning, for example, a P/E of 25 equals a yield of four per cent. A rupee investor can get a far higher risk-free yield from safe debt instruments-even a bank fixed deposit offers more.
However, a Japanese investor, or euro investor, both receiving negative yields, would consider P/E of 25 a great bargain. A US investor who is getting yields of 1.5 per cent on a 10-year treasury bill may well consider a P/E 25 a good deal. A FPI has to take account of the currency risk, but even the current Indian valuations may be attractive.
The optimistic investor will hope the current situation continues until Indian earnings recover. The pessimistic investor will note that the valuations are at the sort of levels where they have rarely sustained for long in historical terms. Of course, it might be different this time because the overseas investor has a higher appetite for risk. Foreign investors have enough resources to keep prices afloat, even if there's a lot of selling from domestic investors.
Trend-following methods would suggest staying invested with some sort of trailing stop or some other mechanism for booking profits if the market shows signs of tanking. However, it is very hard to construct such a mechanism to sell off an entire portfolio. At best, one can say investors should be prepared to reduce exposure if they feel uncomfortable with the current valuations.
