With Sensex scaling 32,000 and the Nifty within arm’s reach of the 10,000 mark, voices of caution are increasing. Is the bull-run unjustified? Why did stocks move up this calendar? What should investors be doing now? Here are some answers.
Towards the beginning of 2017, there was gloom all around. After Trump took over as the President of the US, there was widespread selling in the global equity market on fears that his protectionist policies will prove to be the undoing of emerging markets and the world economic order. The Centre’s move to demonetise ₹500 and ₹1,000 rupee notes last November had also slowed down domestic economic activity, raising concerns that corporate earnings would be hit in 2017. Expectation of market volatility once the Federal Reserve raised rates and began moving towards monetary policy normalisation also made market participants nervous towards the end of 2016.
But the stock market surprised everyone this calendar by racing ahead, despite all the odds. While the Sensex and the Nifty are up nearly 21 per cent since the beginning of this year, the gain in the smaller stocks has been much larger. The BSE midcap index is up 27 per cent and the smallcap index is up 32 per cent so far this year.
What drove the rally?
The rally has been driven by four reasons. One, stocks were hammered on concerns that demonetisation would severely dent their earnings. As it became apparent that the note-ban had negligible impact on the formal sectors of the economy, stock prices rebounded. Monthly macro data releases and sales numbers from companies in the auto, cement and other sectors further consolidated the belief that the sell-off in stock prices after demonetisation was uncalled for.
The second factor that drove the market rally was the thumping victory of the NDA in the State Assembly elections in March. The day after the election results were announced, the Nifty and the Sensex breached key hurdles, paving the way for a sustained up-move.
The third factor is the surge of liquidity that is flooding the equity market. Fears that there will be volatility once the Fed hikes interest rates in 2017 proved unfounded. Despite the Fed announcing that it would start extinguishing the bonds purchased during the quantitative easing programmes, there wasn’t too much of a reaction from global markets. This is due to the manner in which the Fed has been prepping the markets for this, with adequate warnings. Reduced dependence on stimulus from the US due to continued support from the European Central Bank and the Bank of Japan is another reason why the Fed move did not elicit any reaction. FPIs have continued to pump money into the Indian equity market, bringing in around ₹50,000 crore so far this year. With strong inflows from domestic investors into mutual funds, the rally has been powering ahead.
The fourth reason for the market’s buoyancy is the successful rollout of the GST. There is no doubt that the GST will be beneficial for listed companies over the medium term. This will come about because the kicker to GDP growth due to GST will percolate to the bottom-lines of the corporates. With many unorganised players falling into the tax net, the benefit they enjoyed in pricing will disappear, leading to greater profits for listed companies. Tax incidence on many companies is also likely to move lower due to the Input Tax Credit on services and other payments that were so far not available. Finally, the logistics expense of many companies is set to move down sharply due to decline in transit time as the number of check-points reduce and consolidation of warehouses takes place. Sectors such as cement, steel and chemicals will gain due to this cost reduction.
Frothy valuation?
Besides these factors, many companies in the commodities sector have recorded a turnaround in their operations in the last two quarters due to revival in global commodity prices. Earnings of banks are beginning to look better due to lower provisioning. These factors have helped the earnings of companies to grow in double-digits in the March 2017 quarter.
Price Earning multiple of sectoral indices such as healthcare, oil and gas, IT and capital goods have not changed much since the beginning of this year. Froth is appearing only in the realty sector where the PE multiple moved up from 34.7 towards the end of 2016 to 55 now. FMCG, auto, consumer durables and banking are other sectors where valuation has become a trifle rich due to investors chasing these stocks relentlessly; given their high growth prospects.
The run-up in these stocks has taken the Sensex PE, on a trailing basis, to 23.7. This is at a premium to its five-year average valuation of 20.8. The range for five years is 16.5 to 26.78.
To sum-up, stock prices are running beyond their fundamental worth in many segments, but it would be wrong to say that the current bull-run is unjustified. There are structural shifts taking place in the economy that stock prices are factoring-in in advance. While market corrections are possible, these are likely to be shallow, shaping into sideways consolidation moves.