India’s stock market valuations are completely out of whack with reality

The inflow of cheap foreign money, rather than the underlying fundamentals of companies that is fuelling the stock market boom. Experts say this rally will persist as long as the funds continue to flow. But individual investors should ride this rally with great caution.

Is India in the midst of the “mother of all bull markets” or is the exuberance of stock market investors an overreach that will burn several fingers?

As the S&P BSE Sensex crossed the 50,000-mark on January 21 – and with expectations that it can scale still higher levels – the Indian stock market community is divided whether this uptrend is sustainable.

P-E ratio out of whack with long-term average

The price to earnings (P-E) ratio of the Sensex is at more than 34 compared to the long-term average of 21.8. The P-E ratio indicates the amount of money investors are willing to pay for a stock for every rupee of profit the company earns. The high P-E ratio indicates that the market is heavily overpriced.

Many leading institutional and individual investors have been staying away from the market for the last few months as it continues to heat up everyday but the continuous rise in prices has confounded and even frustrated them. Did they read the signals wrongly?

Stock prices divorced from reality

Not really. The stratospheric levels being scaled by various indicators – the Sensex, the Nifty and other sectoral indices – are completely divorced from India’s economic reality.

Reserve Bank of India (RBI) Governor Shaktikanta Das flagged this phenomenon in his foreword to the central bank’s latest Financial Stability Report, which was released on January 11.

“The disconnect between certain segments of financial markets and the real economy has been accentuating in recent times, both globally and in India… Stretched valuations of financial assets pose risks to financial stability,” he cautioned.

Das’s words of caution are well timed. Consider this: After touching a then all-time high of 41,994.26 on January 14, 2020, the Sensex crashed to a recent low of 25,981.24 on March 23 on the back of an economic slowdown and news about the rising tide of Covid cases across the world.

Since then, it has rallied almost 100 per cent even as the real economy, from which the markets ostensibly take their cues, has contracted, taking India into a technical recession from which it is expected to exit in the current quarter.

Massive job losses

The world’s most stringent lockdown resulted in the closure of 65 per cent the Indian economy, led to severe supply and demand disruptions and resulted in almost 20 million job losses in the formal sector alone. There are no reliable estimates for the informal sector, which accounts for 93 per cent of all employment in the country.

Economy clawing back to normalcy

The RBI now estimates that the economy will shrink 7.5 per cent during the financial year ended March 31, 2021, an improvement from the projections of a double-digit contraction many global brokerage houses had been expecting earlier.

But this, and the expected 10-12 per cent growth rate in the coming fiscal year cannot really explain the market rally. That’s because despite the return to the high growth trajectory next year, the Indian economy will still be 2-3 per cent smaller in real terms compared to where it was in January 2020.

Analysts say the far reaching reforms initiated by the Modi government can’t also explain the levels to which Indian stock prices have risen.

Cheap foreign money pushing stock valuations

The main factor pushing up Indian stock valuations is the flow of cheap foreign funds into emerging markets, including India. The rise in India’s weightage in the MSCI Emerging Markets Index, on which a vast majority of foreign funds based their country allocations, has only aided this process.

Safe haven instruments like US Treasury Bills give negligible returns. So do the papers of most developed countries. The alternative for these fund managers is India – and other EMs.

Too much money chasing few stocks

It’s the classical definition of inflation at work – there’s too much foreign money chasing too few stocks. Add to this the frenzy of domestic investors who have joined the party and it becomes evident why the much-awaited correction in valuations has been pushed back. And the weakening of the dollar has only accentuated this trend.

However, all this is not to say that there aren’t any bright spots for the Indian economy. The early and widespread rollout of the two Covid vaccines is considered a huge positive for the Indian economy. It will help remove fear from the minds of people and encourage them to start spending again.

Reforms measures to boost growth

Then, the slew of reforms – in farms laws, labour laws, the production-linked incentive scheme to attract foreign investors to set up factories in India, the massive improvement in India’s rank in the World Bank’s Ease of Doing Business Index, etc. – will put the economy back on the high growth trajectory and enable India to reclaim its position as the fastest growing major economy in the world in the coming year.

Rally expected to continue

Naveen Kulkarni, Chief Investment Officer of Axis Securities, a leading domestic investor, accepted that it was the deluge of cheap foreign money inflows that is driving the market rally. So, he expects the rally to continue as long as the global liquidity situation remains easy. Then, the much anticipated improvement in quarterly results will also help keep valuations elevated for a while.

But individual investors will do well not to forget the old adage, “what goes up must come down”. They must also bear in mind that it is not the fundamentals of individual companies or the Indian economy that is driving the rally in stock prices, which is being driven by extraneous factors linked to the ground realities of other countries.

Therefore, they will do well to exercise caution when investing in Indian stock markets. Rather than investing directly in individual companies, investors will do better if they, instead, put their money into mutual funds. That, most analysts concur, will be the safest option for now.