SEBI (Research Analyst) Registration Number: INH200004471


28 August 2017

Markets at a crucial juncture


The Indian stock markets are at a crucial juncture. Why and what is the road ahead is the focus of this post. The markets have seen a big upside over the last few months and this upmove has not seen any significant correction.
In a previous post, we had written of how stock prices can move up significantly without any serious expansion in earnings (Refer: 600% Gains in PC Jeweller). The same rule applies to the broader market index as well! (After all, indices are composed of individual stocks). Let’s look at what has been the primary driving force behind the rise in the Indian stock markets over the last four years.

NIFTY50

We will use the Nifty index for our research. To being with, lets compare how things have changed for the index between 2013 and 2017.

The above table draws a comparison between the Nifty index on dates that are four years apart. While the index itself has risen by 16.85% p.a., it’s earnings have grown at a snail pace of 2.77% p.a. (CAGR over four years).
The Indian markets have seen a major phase of re-rating backed by factors such as:
  • Government with a clear majority at the centre
  • Positive tax reform (GST)
  • Confidence of sustained high corporate earnings growth rate
Now, the markets ideally move up when earnings go up OR when PE expands. As the above table shows, earnings have increased slower than the GDP and even slower than the inflation growth rate!

PE Ratio


There is no further room for the PE to expand. It is at historical high levels on the valuation scale and at the most we see a 10% upside solely based on PE expansion. A high PE denotes high hopes from investors and the investor community is expecting high rates of growth going forward.

 Earnings


Earnings growth has stagnated since 2015. NPA Mess, Demonetisation and GST transition were dampeners for any expectations of earnings recovery, although these events were just a bump. If India’s GDP is to grow at 8% p.a and inflation is to grow at 6% p.a. then corporate earnings have to grow at 14% p.a. Earnings recovery is expected over the next two quarters.

Crucial Juncture

If we do not see a recovery in earnings then the premium that the market is commanding will go down closer to it’s mean (PE of 19). While we do not see any reason for a 2008 types meltdown, a ~ 12% to 15% broader market correction is possible due to high valuations coupled with no earnings growth.
  • Scope of rerating – NIL
  • Scope of earnings growth – HIGH

Right Time To Invest?


In 2000, the PE ratio of Nifty was 28.47. In 2008, the PE ratio once again reached a peak of 28.29! Now if an investor had invested at the dot-com peak of 2000, he still would have made 17.28% p.a. returns over 8 years! This proves that investing for the long term removes the risk of market timing.
Also, we are nowhere near the bubble type valuations of 2007. Just look at the following comparison:

The biggest difference between 2007 and 2017 is that 2007 was the top of the earnings growth cycle while 2017 is near the lows of the earnings growth cycle. Going forward, Nifty can grow by 12% p.a. over the next 8 years if earnings grow consistently at 14%-15% p.a. and higher. Also, apart from PE, no other metric is near the 2007 valuations peak.

Stock Selection

This is the real test for investors. The last 3-4 years have been very easy ~ Select any stock and returns just follow. Now, get ready t0 put your skills to test. There are still opportunities of buying very good businesses at fair valuations (not cheap valuations). Try to identify:
  • Companies with strong earnings growth
  • Industry with ample growth triggers
  • Available at fair valuations