What’s driving the investor bet on Sensex stocks

  • On 20 May, the BSE Sensex closed at 39,352.67 points, up 3.75% from its previous close, after exit polls predicted victory for Prime Minister Narendra Modi. On 24 May, the Sensex closed at 39,434.72 points
  • In FY20, the price-to-earnings ratio of Sensex has been the highest in over 20 years

Mint takes a look at what is driving the stock market.

1) Are the current levels of the stock market justified?

Till now, in fiscal 2019-20, the price-to-earnings (P-E) ratio of the 30 shares that constitute the BSE Sensex, India’s most popular stock market index, has been at 28.17. The P-E ratio is the market price of a share divided by its earnings per share. When investors buy a share at a certain price, they are basically paying for the future earnings of that company. So far this fiscal, investors have paid 28.17 on an average for every rupee of earning for Sensex shares. This is the highest average P-E ratio in more than 20 years. Thus, it’s important to understand what exactly the stock market is paying for.

2) Why are investors paying such a high price for shares?

A high P-E ratio means that while share prices are going up, earnings of firms are not. People investing in the stock market hope that as Prime Minister Narendra Modi has a bigger majority this time, his government will initiate another round of reforms on labour, land and capital. These reforms will improve ease of doing business. This will help companies expand businesses and spur the launch of several new businesses, thus creating jobs. The creation of more jobs will help people earn more, leading to greater spending, which will benefit businesses and improve their earnings.

(Graphic: Naveen Kumar Saini/Mint)
(Graphic: Naveen Kumar Saini/Mint)

3) Have P-E ratios ever been so high in the past?

P-E ratios were high in mid-2000, when the dotcom bubble was on, and in December 2007 and early January 2008, when the market was rallying, before the financial crisis set in.

4) What are the other reasons for such a strong market?

In the last decade, the central banks of Western countries, led by the Federal Reserve of the US, have followed an easy-money policy. This allowed foreign investors to borrow money at low interest rates in the West, buy shares all over the world and drive up share prices in the process. In the last few months, the Federal Reserve has more or less signalled that this easy money policy is likely to continue. This has given further hope to stock market investors in India.

5) What about the consumption slowdown?

Investors expect the new government to tackle the consumption slowdown by raising its spending. This is a short-term hope that has driven up the stock market, despite lack of earnings growth of firms. The government needs to avoid the mistakes made in 2008-09, when it increased spending and pushed public sector banks to run an easy credit policy. This later led to high inflation and massive bad loans of those banks.

Vivek Kaul is an economist and the author of the Easy Money trilogy.