19 April 2017

Nifty Valuations: April 2017

Nifty valuations as on 18th April, 2017 are as follows:

The trailing PE of 23.08 is at the upper end of the historical PE levels and above the SD1 (Standard Deviation) level of 22.35. The historical PE chart is given below.

As evident from the above chart, we are trading close to the upper end of the valuation band. It is not exactly a euphoria now but a PE above 24 will definitely sound alarm bells and can give some super fast rallies. The index has been rangebound over the last couple of weeks. Over the last 50 trading sessions, we have seen a 1% plus movement on the index (Up or Down) only on 2 sessions.

India VIX, which is the volatility index is at its all time lows as shown in the chart below.

Volatility cannot remain this low for long. It could make sense going long on December 2017 options and gaining from volatility as and when it comes over the next few months. (Not advising any trade here). Such low levels of VIX are a clear indication of complacency in the market. The markets are under-estimating volatility to a huge extent.

Charts of the PB Ratio and Dividend Yield:

The Price-to-Book chart

The Dividend Yield Chart

On the Price-to-Book and Dividend Yield fronts, we are nowhere near over-valued zones. Infact, we are at a fair value zone. All major corrections occur when all the three measures - Earnings, Book and Dividend are at extreme levels. So whats happening with the PE?

Well, the markets have not really rallied. We are still where we were two years back. On this flat note, some stocks have given 2-3x returns while some are down by 40% to 50%. The action is all stock specific and in the small-mid cap space. The markets are paying such a premium on current earnings because they expect a > 15% rate of growth in the earnings. Till a few months back, we were actually at negative growth on the Nifty EPS. Refer the below chart.

Earnings Growth Chart

EPS Chart

The earnings growth rate has bottomed out and over the last two quarters we have seen a good recovery come in. If the GDP is to grow by 8%, inflation is 4% then corporate earnings should grow by 18% eventually. It is with this expectation that the market is paying such a premium.

The question is - Will earnings grow that fast?

Lets look at what the macro-economic fundamentals are saying:

WPI Chart

The WPI chart shows the rising inflationary trend. Inflation is heading back to the danger zone which reduces the room that RBI has to cut interest rates. The forecast of Monsoon is 96% of average and the IMD has laid to rest the fears of El-Nino but the shortage of rainfall looks highly probable this year too. This won't help in easing the troubles brewing in the agricultural belt. Interest rates still have a lot of room to head lower over the next few years as evident from the chart below.

RBI Interest Rate

Investments have not yet picked up - Neither from the public sector, nor from the private sector. Corporate India is now scared of borrowing money for expansion. Two things, either we will see a huge IPO boom for raising capital OR RBI will cut rates to make borrowing more attractive. IPOs are already creating waves now but the second option (RBI) is where our focus should be on.

Credit Growth - India

As depicted in the above chart, credit growth in India is at multi-decade lows. We expect this growth rate to pickup fast in the next two years. But the trigger for a pickup in credit growth will come from lower interest rates. Rising inflation will not leave any room for RBI to cut rates and this could be a short-medium term dampener.

Investment Portfolio:

How to build a portfolio at these levels? What stocks to hold in the portfolio and what new investments to make? How much allocation to equities, debt and cash?

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