Flush with liquidity, the stock markets are at a dreamlike high. But the worries are also mounting
Many feel the gains have come too fast. With scores of new investors entering the bull market late, and with the cream of the rally behind, further gains are not going to be easy
For the past few days, the Sensex has been flirting with the landmark figure of 50,000. Things have reached such a pass that crossing the magical mark seems to be a matter of course. The Indian stock market’s rise has already been unbelievable, defying all odds.
Just 10 months ago, the Sensex hit a low of 25,638 points. Despite businesses being shuttered and profits being wiped out, stock prices have been in an almost-daily price sprint since then. Small investors who may have lost heavily in the February-March crash have recouped their losses, and then some. The 2020 revival recaptured the peak in less than nine months. Earlier recoveries took longer. After the January 2008 peak, post the Lehman crash, the market took about 70 months to regain its highs.
This run seems almost dreamlike, and worrisome, at the same time. “Right now, stock markets are melting up because of surplus liquidity and a restart of the economic cycle. Hopefully, we will not overshoot like Tesla and come down like 2001," noted a market veteran who did not want to be named. Many feel the gains have come too fast and border on speculative frenzy. With scores of new investors entering the bull market late and with the cream of the rally behind us, further gains are not going to come easy.
Investors are not complaining, though, especially those that have caught the bull market early. The market’s rally is broad-based and spread out across stocks, including even sectors that have been badly hit by the pandemic. The Nifty Midcap 100 and the Nifty Smallcap 100 indices gained about 24% and 19% in the past year.
Since November, after the US elections, more than 90% of stocks have run up the BSE ladder. In other words, if you had thrown a dart randomly at the stock tickers, the odds were high that you would have picked a winner.
The question now is whether investors should continue jumping into the fray. There are no easy answers. Suffice it to say that valuations are uncomfortably high. Stocks have never been so expensive except maybe during the Harshad Mehta fuelled bull run in the early 1990s.
With its one-year forward price-earnings multiple at about 22 times earnings, the Nifty 50’s valuations are highly discomforting. At its peak in 2008, the one-year forward valuation hit a top of 20 times. Stock prices took a big tumble after that. Even some previous rallies peaked around these high valuations.
“Valuations are high on an absolute basis compared to historical levels, whether you look at price-earnings or price to book. At 22 times FY22 earnings, valuations are well above the long-term average," said Sanjeev Prasad, chief executive officer, and co-head, Kotak Institutional Equities.
It’s the liquidity, stupid
Of course, much of this is thanks to the abundant liquidity driven by central banks trying to save their economies. Some of that trillions of dollars printed are finding their way into emerging markets. In fact, foreign investors purchased nearly $24 billion of equity in 2020, despite the $7.9 billion outflows in the March plunge. The appetite continues in 2021 as well with foreign investors buying stocks worth $2.5 billion in January so far.
India also benefits from having more “quality" companies than some of its Asian peers. An earlier report from BNP Paribas highlights that many good companies are available in India. “India continues to benefit from two phenomena, the big are getting bigger (large stocks primarily constitute the investable market) and quality stocks are available in relative abundance compared with Asian peers," the report stated.
That explains why foreign flows into Indian markets have been better than some Asian peers. Some large Asian counterparts such as Taiwan and South Korea suffered outflows of about $13 billion and $21 billion, respectively, in 2020. Foreign funds pulled out of most emerging markets in Asia.
Hope, of course, is plenty, as global flows could remain high. After a small correction and with the Biden Presidency underway, stimulus packages are again being chalked out to further prop up the US economy. This is beyond the bond-buying programme of the US Federal Reserve.
“Central banks will continue to buy roughly $250 billion a month in 2021, which will inject an additional $3 trillion in the global financial system, about half of it led by the US Fed... India with its natural growth provided by demographics and latent potential will continue to attract risk capital," said Axis Capital in a recent note.
Then again, holding sentiment high is the US Fed pointing out that it will keep interest rates low till 2023, which is near zero. “This is a developed world central bank bull market. However, when viewed in the context of prevailing low-interest rate scenario, valuations appear less expensive. The elevated valuations scenario is likely to continue till the time inflation starts rising in the US leading to the Fed withdrawing liquidity," said S. Naren, ED and CIO, ICICI Prudential AMC.
Investors did, of course, get a scare recently when long-term interest rates in the US inched up. The US 10-year treasury has inched up to about 1.18% in yield from about 1.05% and spooked global stock markets. Indian markets were also not spared.
“This time, the markets are led by a mix of improving fundamentals and liquidity infusion by global central banks. It is a tough question to answer as to what extent the premium is justified as the global liquidity infusion is not going to slow down in the near term," said Amit Shah, head of research, BNP Paribas India.
The earnings game
With the markets already having recovered sharply, some of the gains are pricing expected earnings growth. Sure enough, earnings are expected to rebound considerably during Q3, but stocks already have high valuations. For instance, on its trailing earnings, Asian Paints Ltd’s price-earnings multiple is 95.5 times (based on FY20 earnings). Hindustan Unilever Ltd’s PE is hovering around 75.5 times.
“Earlier, valuations of consumer and paints stocks implied decent double-digit growth for about 10 years and then the usual terminal rate of growth of 5%. At current valuations, markets are betting on strong growth for about 20 years. Investors are clearly setting themselves a very high asking rate of future growth expectations," said a former fund manager on condition of anonymity.
Some sectors have already shown remarkable recovery in the recent past. Nifty IT index gained 64% in the past year, while the Nifty Pharma index gained 56%. Core sectors such as metals and infrastructure, which have been more badly impacted by the pandemic, are also up about 21% and 18% in the past year. This also means that stocks that are considered valuable are no longer inexpensive. Metal stocks such as Tata Steel Ltd and Hindalco Ltd are already over their pre-covid highs.
Some of the more badly-hit sectors of the economy such as tourism and entertainment are also putting up a smart show of resilience. The Indian Hotels Ltd stock is just about 16% away from its pre-covid high, despite having lost a lot of business lately. PVR Ltd is also rebounding well and is just about 25% away from its pre-covid highs, on the hope that people will flock to theatres once the vaccine is rolled out.
The fall in covid-19 cases is also encouraging, which is keeping investor hopes alive that earnings could recover more sharply as economic activity recovers. Already, some indicators are pointing to a decent inprovement in the economy. Demand for fuel, power and other services is now back to pre-covid levels. Passenger vehicle sales are bouncing back, while two-wheeler demand has been resilient.
The street is expecting the Nifty 50 profit growth to be in double-digits this year. It’s also expected to be the best quarter in the last five. Kotak Institutional Equities expects around 19% year-on-year net profit growth in the third quarter. The street expects a sharper recovery in some cyclical sectors.
However, whether this is enough to ease the pressure on soaring valuations remains to be seen. The recovery has to be much better than expected to at least ease valuations.
“What makes us cautious on the markets is that FY22 earnings today factor in 36% earnings growth. When we take a closer look, autos and metals are expected to grow at 110% and 47% respectively, which seem a bit stretched. Financials and telecom are sectors we think will continue to do well relative to expectations. We do not expect a sharp correction in the market but we do see sector rotation as a play for 2021 making stock-picking imperative," said Shah.
Besides, of course, if some of the earlier quarters are much better than expected, it will put pressure on earnings in the latter quarters. In addition, some of the cost-savings during the pandemic are likely to come back later. In the case of IT stocks, work-from-home has driven an EBIT gain of about 2-5%, say analysts, but that could come off as people start to work-from-office.
Even so, some early third-quarter numbers have set a good tone for this quarter. Mainline companies such as HDFC Bank Ltd reported a good set of numbers with a dip in non-performing assets. IT majors reported an expansion in earnings, thanks to a pick-up in digital transformation. Titan Ltd, Marico Ltd, Godrej Consumer Products Ltd and even auto original-equipment manufacturers indicate that Q3 results would be better than forecast.
Of course, how well Indian companies recover will be known only in the next few quarters. If there is indeed a sharper increase in earnings, it will help check the soaring valuations, and that should be good to support stock prices.
There are many risks. A key one is a spike in global inflation. “The risk is inflation surprises on the upside, which means the Reserve Bank of India may be forced to increase rates to clamp down on inflation," points out Kotak’s Prasad.
At higher levels, stocks are more vulnerable to a downward pressure, and the higher it climbs, the more pronounced the risk. When the previous US Fed governor Ben Bernanke first talked about tapering, emerging-market stocks tanked. The taper tantrum caused considerable damage to investor confidence and stock valuations.
“With stock valuations already quite high, there’s limited scope for re-rating higher. If anything, the risk is on the other side—of interest rates surprising on the upside. A positive surprise, if any, could come if you see earnings upgrades and if the economic recovery is a lot stronger," said Prasad.
Investors are, no doubt, pinning high hopes on the economic recovery. With the vaccine roll-out, there is a chance that the economic recovery could be better. Further, the upcoming Budget is also expected to continue to stimulate the economy. ICICI Prudential’s Naren sees the central banks driving markets over the next decade.
But given the stock markets are already at highs, investors may start to take riskier bets to bolster returns. As one fund manager recently said, with stocks at high valuations and bond yields abysmally low, the challenge for an investor is to find good investments at a reasonable value. That’s the test for 2021.
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