The BSE Sensex flattered to deceive on Monday, 2 July, falling sharply after reaching an all-time high. At Monday’s close, the Sensex is up merely 0.64% from its close a month ago on 1 June. Most of the gains have happened recently, with the Sensex moving up 1.22% in the past week.
It’s also interesting that BSE Mid-cap and Small-cap indices have performed better than the Sensex in recent times, going up by more than the benchmark in the past month. Does this indicate a broad revival in the market? Two factors need to be considered—the fundamentals and liquidity.
As far as the fundamentals are concerned, the fall in inflation has led to a renewed belief that the Indian economy is capable of strong growth without overheating. But first quarter results are unlikely to be very good and are likely to underline the negative trends in earnings growth that surfaced in the March quarter.
On the liquidity front, both net inflows into mutual funds and FII inflows (taking inflows into futures also into account) are dwindling. According to EPFR Global, net inflows into emerging market funds were down sharply in the first half of 2007, compared with the year-ago period, with inflows into Asia ex-Japan funds turning negative. And the full impact of the inflows into new equity issues are yet to be felt, as the money bid by institutional investors is paid up.
In short, the market is powering ahead despite several headwinds, inclined to believe that we are already at the top of the interest rate cycle, that we have achieved a soft landing. And a dip in earnings, even if it occurs, will soon be reversed. But there is a deep dichotomy in the market, as the sectoral indices clearly show.
While the rally has been powered by banking and capital goods stocks, the IT, FMCG and auto indices have been laggards. The saving grace is that, at current levels, the Sensex is at a price-to-trailing earnings ratio of around 21, compared with 22 when it reached its previous high last February.
Bank stocks have led the market in recent weeks, easily outperforming the Nifty. The Bank Nifty Index was up 11.3% in June, compared with the 5% gain in the Nifty. That has been explained by the fact that inflation has been falling like a stone and concerns about an interest rate hike by the central bank in its July policy statement are rapidly fading.
But it’s not only in the last month that the Bank Nifty index has outperformed the Nifty—it has beaten it in the last three months and over the last 12 months as well, and it was only in the first three months of 2007 that bank stocks slowed their rapid rise. The upshot: a steady rise in the valuation of the bank index from 1.8 times book value a year ago to 2.8 times currently. In other words, the rise in bank stocks in the past year has been on account of a re-rating of these stocks, rather than on earnings growth. And while the Reserve Bank of India’s decision not to raise interest rates at its 23 April policy meeting provided a strong push, most banking stocks had already been re-rated prior to that date: The price-to-book ratio of the Bank Nifty index was 2.5 on 20 April. That means bank stocks had already moved up although inflation was going up, interest rates were rising and there were worries about bad debts.
Now consider the current environment. While it is true that inflation is dropping and the outlook for interest rates is far better than what it was a couple of months ago, it is also true that credit growth has slowed sharply. More importantly, most banks have announced huge capital issues, which will dilute their equity. Some banks will also take a hit on implementation of the Accounting Standard 15 guidelines for pensions. Recently, reports have surfaced about banks selling their retail non-performing assets (NPAs) to the asset reconstruction firms.
In other words, investors are betting on several things: that while credit growth may slow, it will still be robust; that while banks may dilute equity, they will easily be able to ramp up their operations to lend the money raised quickly; that NPAs will not be a problem; and that there will soon be unlocking of value by listing subsidiaries or holding companies for their insurance businesses.
SBI and economy
If we were to pick one stock that is a bet on the economy, that stock would be State Bank of India (SBI). Investing in SBI, which has an exposure to practically every economic activity in this country, is a proxy for investing in the economy. The fact that the SBI stock reached a new high on Monday (it ended at Rs1,530.80), along with the Sensex, is a sign of the market’s renewed faith in the strength of the economy, a faith that had been tested in recent months with worries about overheating.
The immediate trigger for the stock’s recent rise, however, was the SBI chairman outlining his plans to enter several new businesses and unlocking value by floating a holding company for its insurance and other non-banking businesses last week.
But the chairman had already talked about these plans earlier, at the time when the bank declared its fourth quarter results in mid-May, which had led to a spurt in the stock then. That seems to indicate that the reason for the recent surge is the improved outlook for inflation.
But is the value of that improvement worth a 38% rise in the stock in the past couple of months?
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