Mumbai: Conflicting signals from economic and corporate fundamentals are stoking concerns about the sustainability of a stocks rally that has made Indian markets the most expensive in a decade. Falling earnings estimates, a weakening rupee, rising oil prices, a widening current account deficit and global trade tensions are some of the reasons why investors are worried that the markets may have run ahead of fundamentals.
The 50-stock Nifty index now trades at a 12-month forward price-to-earnings (P-E) ratio of 18.65 times, compared with 11.74 times on 15 September 2008, a day after Lehman Brothers filed for the world’s largest corporate bankruptcy, triggering a global stocks rout, according to Bloomberg data.
For fiscal 2019, the earnings estimate for Nifty firms has been cut by 5.2% since April, while for fiscal 2020, it is down 5.5%. Contrast this with Nifty’s current P-E ratio, which is 12.9% and 24.7% higher than the three-year average and 10-year average, respectively.
The Nifty is up around 11% so far this year, riding on a massive rush of liquidity from local investors. Domestic mutual funds and insurers have pumped in ₹ 69,653.3 crore into Indian stocks since the beginning of 2018, while foreign investors have sold shares worth $342.57 million during the period.
Though the markets have touched record highs multiple times this year, only a few stocks are driving the rally. Only seven of the 50 Nifty stocks have gained more than 30% year to date. The BSE Midcap index has lost nearly 14.7% in 2018 so far.
The Indian market is still the most expensive among peers and an earnings recovery critical at this juncture may get derailed due to high crude prices and a weak local currency.
Meanwhile, global central banks are reducing their balance sheets, which could reverse foreign inflows.
According to Edelweiss Securities Ltd, Nifty earnings per share was downgraded by another 2-3% post Q1FY19 earnings, but the bulk of downgrades has come from the “very high growth" category classification, while “high growth projections" and “moderate growth projections" have been broadly maintained and remained stable.
“While Nifty EPS estimates have been cut, markets have rallied, leading to a big re-rating. The result of this re-rating is that Nifty one-year forward EPS is highest since the Lehman crisis and is now more than one standard deviation above its long-term average," it said in a report in August.
The brokerage firm added that within Nifty, while very high growth sectors have underperformed in FY19 to date, in Q2FY19 so far, they have actually outperformed and that, too, despite sharp earnings cuts for them because of which it has become more expensive.
Kotak Institutional Equities also agrees that valuations are heady and macros weak, with rising external risks.
“We find the valuations of the Indian market to be rich and note the significant disconnect between high equity market valuations and weak macroeconomic outlook, as can be seen in the divergence between bond and equity yields," it said in a report on 14 August.
According to Kotak, markets have been driven by rich valuations of certain stocks in the private financials, consumer staples and discretionary sectors, apart from Reliance Industries Ltd and IT stocks. Kotak expects a further re-rating of certain banks, gas and metal companies on positive sector- and company-specific developments, leading to some convergence between the valuations of the expensive “growth" stocks and inexpensive “value" stocks. “Further deterioration in the macro could delay the ‘convergence’ but also pose risks to rich valuations of ‘growth’ stocks. The market has so far ignored India’s weak macro and rewarded the IT sector with a massive re-rating given currency-led higher earnings," it added.
Other brokerages broadly agree. Nomura said in a 21 August report that the strong run-up in certain stocks this year has led to stretched valuations that imply expectations of very high growth, leaving little scope for a slip.