The Dalal Street party is getting a little wild
Indian equity markets have been looking frothy for quite some time now. They tested new highs this week even though corporate earnings growth in the fourth quarter of the previous fiscal year has been sluggish. It is no secret that equity prices are being powered by excess liquidity—not just global liquidity, as has usually been the case, but also strong inflows into domestic mutual funds because of the systematic investment plan (SIP) revolution.
The benchmark S&P BSE Sensex has gained over 13% so far in 2017. The Sensex is now trading at a price to earnings (PE) ratio of about 23 compared with a 10-year average of about 19. Valuations of mid-cap companies make little sense right now. The implied volatility in option contracts is now at its lowest level in several years. The Indian market may not yet resemble a bubble—but it is definitely heating up too rapidly.
The strong domestic buying has positive implications, to be sure. Indians have traditionally been averse to building wealth through financial assets, preferring physical assets. Is that changing? The macroeconomic implication is that more financial savings could be available to fund the next capex cycle. The microeconomic implication is that more Indians can benefit from strong corporate growth rather than see the value of their bank deposits getting eroded by inflation. The fact that a lot of the domestic buying is being done through SIPs also means that Indian households are not entering the party at its wildest moments, as was the case in 1992 or 1999 or 2008.
Foreign investors have bought shares worth over $5 billion so far in 2017. Similarly, domestic institutional investors have also been large net buyers because of strong inflows into mutual funds. Even though foreign investors sold stocks in April and May, domestic funds continue to flow into the market. Retail investors are showing renewed faith in the market, which is reflected by the rising number of mutual funds folios and increasing participation through SIPs. Data compiled by Howindialives.com shows that SIP contribution increased from Rs3,122 crore in April 2016 to Rs4,335 crore in March 2017. On an average, over 600,000 new accounts were added every month in the last financial year. Increasing participation by domestic investors has provided significant strength to the market. It also indicates that household savings are finally shifting to financial assets.
However, India is not the only market that has gone up, and it is certainly not the only place where valuations are becoming uncomfortable. Markets in the US have gained significantly since the victory of Donald Trump in November, in anticipation of higher government spending and lower taxes, among other things. The cyclically adjusted PE ratio (Shiller PE ratio) for S&P 500 in the US is at 29.19, compared with the historical average of 16.75. This does not mean that stocks cannot move up from present levels. In the short run, they often tend to overshoot. Apart from valuations, there are a number of other risks that could trigger a correction in global markets which will affect prices in India as well. First, the recent fall in commodity prices could result in global risk aversion and lead to a correction in stock prices. Also, a fall in commodity prices can affect the earnings of listed companies in the business.
Second, policy developments in the US could affect markets. The inability of the Trump administration to push expansionary fiscal policies could be a risk for the market. Protectionist policies being pursued in the US are also negative for markets and will have a direct impact on the earnings of information technology services companies in India. At a broader level, it will also affect trade and global growth. The tightening of financial conditions due to interest rate hikes by the US Federal Reserve is also a threat. Third, even though things are looking a bit stable at the moment, high leverage and economic rebalancing in China remains a risk for global markets. Fourth, geopolitical issues such as increasing tension between the US and North Korea could also destabilize stock markets across the world.
For the Indian markets, apart from international factors, a prolonged period of subdued earnings is the biggest risk. Investors in India have waited a long while, but if earnings don’t recover soon enough, they might start losing patience and the increasing participation of retail investors could get tested. Retail participation typically increases with rising markets. For example, domestic institutional investors were net sellers during 2012-14 after markets fell by about 25% in 2011. They turned strong net buyers in 2015 on an annual basis as markets gained about 30% in 2014. It would once again be interesting to see how retail investors react in case there is a sharp correction. Continued flow of funds will further push markets into the overvalued territory, as fund managers will have to buy stocks even at higher levels, which will increase risk in the absence of earnings support.
India remains one of the few vibrant economies in the world—but investors should worry about the valuations at which they are buying shares.
Is the Indian stock market overvalued? Tell us at firstname.lastname@example.org.