Business Today

A Lot of Bull

Why the sharp recovery and sustained run in stock markets is built on weak fundamentals. Despite the fall, they are trading at double the valuation of the 2008 Lehman crash
Rashmi Pratap | Print Edition: July 12, 2020
A Lot of Bull
Illustration by Raj Verma

Tight turns, steep slopes, sudden highs and inversions are characteristics of a roller coaster. Those have also been the hallmarks of the Indian stock markets for close to three months. From hitting a three-year low on March 23 with a 13 per cent fall to bouncing back just three days later, it has shown deep falls and sharp recoveries time and again.

But don't get fooled by that. There may be a storm brewing beneath the calm. After all, this sharp recovery is built on weak corporate and economic fundamentals and huge uncertainty in the immediate future.

With India's economy projected to shrink 6.8 per cent in FY21, according to SBI Ecowrap (it grew slowest in 11 years at 3.1 per cent in the March quarter), early bird corporate results showing sharply shrinking top lines and bottom lines, stock markets are set to lose the only basis on which they have been rallying - the hope of a 'V' shaped recovery.

The optimism is dimmed further by rising coronavirus cases in India and fear of a second wave in the US, the world's largest economy, which has led to a selloff in S&P 500, the global barometer for equity markets, as well.

Add to this the lockdown-triggered defaults feared in housing, credit card, personal and corporate loans, their impact on non-performing assets (NPAs) of banks and non-banking finance companies (NBFCs), and the stock market rally appears to be on a very, very weak wicket. "The economy is in shock. All indicators are showing that the situation is very bad. Fundamentals of the stock market story are very weak," says Dhananjay Sinha, Head of Research and Equity Strategist, Systematix Group.

Analysts say markets go through three-four stages when hit by an unknown factor such as coronavirus. "Covid-19 hit us in January from a China perspective. India started reacting to it the last. The first stage is extreme over-reaction as nobody knows what is happening. So, markets tumbled in March," says Amit Shah, Head of India Equity Research, BNP Paribas. But, the government lockdown prompted markets to get out of the first phase of irrationality. Then, the second leg - recovery - began. "We remained in lockdown. This helped control spread of the virus and indicated, from the market's perspective, that the worst is behind us," Shah adds. But that was not to be. In June, the market is at stage three when people are beginning to look at fundamentals after stability has returned and are closely monitoring the spread of Covid in India, besides a potential second wave globally, he says. "The longer Covid stays, the slower will be the FY22 earnings recovery. The market is already looking at FY22 for cues."

Sensex shed 3,935 points with a 13 per cent fall to 25,981 on March 23 with all its 30 stocks in the red. Just three days later, it bounced to 29,947 points. It had hit an all-time high of 42,063 on January 17. On May 18, it hit a low of 30,029 again, touched 34,370 on June 8, and on June 15, was at 33,605, up 29 per cent from March lows.

The Sensex rose nearly 5,000 points from May lows in less than three weeks. It fell nearly 5 per cent in five days up to June 15 due to worries over worsening fundamentals.

On Weak Wicket

Corporate earnings, a big factor driving stock markets, will take a bigger hit in the first quarter of FY21 after being severely impacted in Q4 of FY20. Since the lockdown was imposed on March 24, manufacturing plants have been shut, and consumption, barring of staples, is down. Auto sales were nil in April and down 87 per cent in May. The June quarter is expected to be a washout due to very low economic activity in the first quarter so far.

Last month, government announced an economic package worth Rs 21 lakh crore to battle the slowdown, including the Reserve Bank of India's Rs 8.01 lakh crore liquidity measures. The package included Rs 3.70 lakh crore support for MSMEs, Rs 90,000 crore for power distribution companies, Rs 75,000 crore for NBFCs and Rs 15,000 crore for the healthcare sector. This, too, failed to enthuse markets. The reason is simple. Economists and brokerages believe that out of this package, the government's fiscal commitment is less than Rs 2 lakh crore, or a measly 1 per cent of GDP, one-tenth of the headline figure.

This means no boost to purchasing power of workers and consumers that can affect demand for all kinds of products from soaps and garments to mobile phones and cars. This is exactly what is happening. In Q4 of FY20, the combined net profit of 532 companies that had declared results till June 11 fell 39.5 per cent, against growth of over 59 per cent in Q4 of the previous year. Their revenue performance was the worst in 12 quarters (4.7 per cent fall). "We have cut banks and NBFCs' earnings forecast by 40 per cent, oil and gas companies' by 25 per cent and that of automobile players from 10 to 100 per cent. We see a 15-25 per cent earnings hit for FY21 (overall). The math is that when you roll it over, you see a hit of at least 10 per cent on FY22 earnings also," says Shah.

The worst-hit are consumer discretionary, NBFC and real estate sectors where highly leveraged companies are likely to face sharp cuts in earnings estimates. "Our analysis reinforces the point that markets have priced in a mild recession, but not a severe one, which could take the Nifty further lower, depending on the prevailing risk aversion," he adds.

In FMCG, Hindustan Unilever, the biggest player in the sector, reported its lowest revenue in nine quarters, while Reliance Industries, (RIL) India's largest private sector company, reported its steepest drop (of 39 per cent) in quarterly profit in at least a decade at Rs 6,348 crore as refining business took a hit due to collapse of crude oil prices. Its FY20 net profit was a flat Rs 39,880 crore.

A fall in earnings will make Indian markets look even more overvalued. As it is, India's GDP produces considerably lower profits for India Inc. compared with other major economies. In CY2019, the combined net profit of listed companies in India was equivalent to 2.1 per cent of GDP as against 3.7 per cent in China, 2.3 per cent in Indonesia, nearly 5 per cent in Japan and 9.6 per cent in the UK. "Since future earnings scenario is not yet clear, we don't know how badly affected the numbers will be. The market is over-valued because it is still not the bottom yet," says Shankar Sharma, Co-Founder and Chief Global Strategist at First Global.

Shallow Rally

The rally as well as the recovery is driven by a handful of stocks. The top 10 stocks accounted for 75.3 per cent rise in indices between March 23 and June 12. Despite a relatively poor show in the March quarter, RIL and HDFC Bank, along with Infosys, made up nearly 43 per cent rise in the Sensex from its 52-week low on March 23. In all, these three entities have added around Rs 6.3 lakh crore to market capitalisation since March 23 as against Rs 14.5 lakh crore rise in value of all 30 Sensex companies. Hence, the rally is susceptible to reversal in case of negative news about any of these stocks.

Clearly, the equity market funnel has got narrower than in the pre-Covid-19 period. Add Hindustan Unilever and Bharti Airtel to the list, and the five stocks accounted for 55 per cent of incremental rise in the Sensex between the March 23 low and June 13. "There has been a rally in sectors that are projected to be least affected by lockdown - telecom, crude oil refining, banking, FMCG, pharmaceutical and technology, while others continue to languish," says G. Chokkalingam, Founder and Managing Director of Equinomics Research & Advisory Services.

"The April rally was based on large-caps, as in March. Correction in large-cap stocks was much steeper than in mid- and small-cap stocks. Mid-caps have not been doing well for the last two years. So, large-caps were squeezed out in March, and when they bounced back, they provided the returns," says Siddharth Sedani, Vice President, Equity Advisory, Anand Rathi Shares and Stock Brokers. Moreover, some big companies like RIL were in the news (the mega rights issue and stake sales in Jio Platforms), he adds.

Shankar Sharma of First Global says even as the lockdown is selectively lifted, there is no clarity on how economic activities will resume. "And if at all a large part of the economy will come back. That is the larger question."

Debt and Delinquencies

The biggest unknown is corporate and individual delinquencies. Crisil's Srinivasan expects gross banking NPAs (GNPAs) to go up in FY21. They were 9.5 per cent at the end of March 2020. "If we see that scenario (of negative GDP growth), banking GNPAs can slip 350-400 basis points compared to FY20. In NBFCs, the situation could be worse, with GNPAs expected to rise sharply in wholesale finance, microfinance, MSME lending and personal loans," he adds.

Given the sharp slowdown in economic growth, Srinivasan sees a sharp rise in corporate sector defaults, with MSMEs being hit the most. "Industries like textiles, gems and jewellery, auto, infrastructure (power) and construction pose higher risks. In services, transport, tourism, hospitality, commercial real estate and trade are expected to feel the pinch of lockdown and sluggish economic activity," he says.

This slowdown will also impact personal debt. "In our base case scenario, we have not factored in large job losses and salary cuts. Personal loans are more likely to be impacted by the current scenario given that most are taken for emergency or discretionary spending under certain assumptions of income certainty and growth," says Srinivasan. Within the category, smaller personal loans (less than Rs 1 lakh) are likely to see more delinquencies. "In home loans, too, we expect asset quality to deteriorate, with affordable loans, which cater to the self-employed, being hit more than others. Unsecured loans, which have seen sharp growth in past few years, are likely to be hit the worst," he adds.

Arindam Som, Senior Analyst at India Ratings and Research, says the downgrade-to-upgrade ratio in rated mid and emerging companies' portfolio rose to 2.85 times in FY20 from 1.28 times in FY19. "Lower-than-expected operating cash flow will weigh on ability of issuers to deleverage balance sheets in FY21, and in certain cases, the quantum of outstanding debt could even be increased to fund cash flow mismatches."

Valuation Free from Fundamentals

The Sensex is down close to 19 per cent from its peak. In spite of the fall, it is trading around 21.81 times trailing earnings, and is nearly twice as highly valued as it was during the 2008 Lehman crisis (11.5 times). This is even higher than the 18 times at the start of Narendra Modi's election campaign in December 2013 and similar to December 2016 after demonetisation triggered a brief sell-off.

"They are clearly overvalued. The future earnings picture is not clear, the government has no money, consumers have no money and companies have no money. Without money, what will you get even after lifting the lockdown? Any loss-making entity is always overvalued," says Sharma.

Chokkalingam says when markets crashed in March, many retail investors believed it had bottomed out and invested. "Other retail investors bought to make up for their losses. And those who were sitting on the fence, and had idle working capital due to closure of businesses, also entered the market," he says.

The Indian stock market remains over-valued compared to those in other emerging economies. India's market capitalisation to GDP ratio is 60 per cent, among the highest in the emerging markets group but lower than developed markets such as the US, the UK and Japan. For China, the figure is 55.5 per cent, while for Brazil, it is 41.6 per cent.

Weak Macros

On the macro-economic front, the stock market is worse off than in the 2008 crash. "Then, every market fell 50-60 per cent. This time, so far, while markets have fallen, there is a big divide between the top five-seven markets and the bottom five-seven markets. The top markets are stronger economies such as the US while the bottom includes India, South Africa, Brazil and Mexico, with poor healthcare systems and lack of financial strength to come out of the pandemic and the resultant economic problems," says Sharma. For instance, the S&P 500 rose nearly 2.7 per cent on June 16 due to news about a breakthrough in developing a Covid-19 vaccine. It is now just 9 per cent below its record high hit four months ago. In comparison, Brazil's benchmark index is down 20.1 per cent, while Sensex is down 19.1, from their peaks.

The government's poor fiscal situation and decline in barometers of growth such as Purchasing Managers' Index (PMI) for Manufacturing/Services, Index of Industrial Production (IIP) and GDP has also been a drag. In April, India's industrial output contracted the most in at least two decades due to the lockdown. The IIP shrunk 56 per cent in April, the worst fall since at least 1996 and the steepest among major countries during the lockdown. It had contracted 18.3 per cent in March. While CMIE has forecast India's GDP for FY 21 will decline 6 per cent, SBI Ecowrap has predicted a fall of 6.8 per cent. ICRA, S&P, Crisil and Fitch Ratings have forecast a 5 per cent fall. In March 2020, CRISIL Research had forecast a base case view of 1.8 per cent GDP growth in FY21. "However, with lockdown getting extended in major parts of the country, probabilities are getting tilted towards our downside scenario of negative GDP growth in FY21," says Ajay Srinivasan, Director, CRISIL Research.

The IHS Markit Manufacturing PMI increased marginally to 30.8 in May from record low of 27.4 in April but far below the market consensus of 38. A reading below 50 means shrinking of economic activity. It was at 51.8 in March 2020.

All this will limit the government's fiscal space. The government has not released GST numbers for April and May as lockdown would have led to a steep fall in collections. Experts estimate up to 70 per cent decline in tax collections during these two months. "The fiscal situation is terrible. The central government needs money, state governments need money. It's a serious problem," says Sharma.

Chinese Checkers

Then there is China with which India is going through a serious faceoff at the border. It is the world's second-largest economy, top exporter of goods, and the second-largest importer as well. China is also India's biggest trade partner. Given this, corporate earnings and markets are susceptible to developments in China. They will get worse if the call to boycott Chinese products or supplies leads to higher raw material costs for companies importing raw materials from China in sectors such as automobiles, pharma and solar. However, companies in sectors where India is raising import tariffs will report better earnings.

The global sell-off in equities had started with spread of Covid-19 in China and its impact on Chinese industrial production and global supply chains for goods right from mobile phones and medicines to consumer electronics and automotive components.

China is also the world's top market for consumer and capital goods and a significant source of revenue for the world's top companies, including Indian, such as Tata Motors.

The Chinese stock market, the second-largest globally by market capitalisation, has, however, proved to be more resilient to the Covid-19 crisis than most global counterparts. The Shanghai Composite Index fell around 10 per cent in January as virus tally sky-rocketed, forcing a lockdown in the Wuhan province, but it recovered quickly and was back to pre-virus levels in early March. Shanghai saw another 15 per cent decline in March with the rest of the world. But unlike the rest of the world, market recovery in China after the March 23 low has been more gradual. The Shanghai Composite is currently 7 per cent below its January highs. However, for Indian stock markets, the road ahead is likely to be far bumpier than it has been for China so far.

Return of Retail Investors

The April-May rally was driven by retail investors. Domestic retail investors increased participation in derivatives. The futures & options segment accounted for 41 per cent trading volume on NSE in April as against the FY20 average of 38 per cent. Trading volumes were up even in the cash segment with 790 million units of Nifty traded per day on average till June 15 as against 720 million per day in May and 708 million in April.

It is clear that markets have been swinging between hope and despair. There was optimism after the government announced its Rs 21 lakh crore economic package last month. But when details were released, the market was disappointed, and the Sensex fell 9 per cent in just two trading sessions. In last week of May and early June, there was optimism around the end of the lockdown. This has now been clouded by Indias fast-rising Covid-19 tally, which makes it the fourth worst-hit in the world. It has been reporting close to 13,000 new cases in a day.

Sinha says the upswing in Sensex and Nifty in April was a relief rally after the sharp fall in March. As for the market being over-valued, he says: "We have to understand that the link between valuation and underlying fundamentals, whether corporate or macroeconomic, has been broken since 2015. The market shrugged off big events such as demonetisation, roll-out of GST, NBFC crisis and global trade wars," he says. These events shocked the economy and hit corporate earnings but the Nifty 50 multiple kept going up. "In 2013, Nifty 50 was trading at 16 or 17 times trailing 12-month earnings per share, and in January 2020, despite the shocks, it was around 27 times. The correlation between valuation and growth is broken," he says.

There hasn't been a steep correction even now, he says. "The multiple went down to 17 times, seen in 2013 and 2014. The situation then was much better today with good consumer sector growth and earnings numbers," he says. "So, this is the new normal wherein valuations don't fall even after a shock. And possibly, in the current set-up, we have touched the worst valuation. Globally, there is lifting of lockdown, monetary and fiscal stimulus, but not here. History is not the right guide for fair value," he adds.

Portfolio Investors on the Run

Besides poor macroeconomic performance, the pandemic and trade wars, sentiment has also been hurt by the plunge in oil prices, a strong barometer of global consumer/industrial demand. Brent crude prices fell from $60 a barrel around February to $15 before recovering to around $38 a barrel. Low oil prices hurt sovereign wealth funds, which are big investors in equity markets globally, including in India.

This explains why foreign portfolio investors played it safe in February, March and April. They withdrew Rs 59,000 crore in March, Rs 14,859 crore in April and Rs 7,356 crore in May. "They were playing safe and avoiding risks," says Sedani.

But they turned buyers in June and invested a whopping Rs 23,335 crore during the first 15 days of the month. This is in line with the surge in global liquidity due to monetary expansion by the US Federal Reserve, the European Central Bank and the Bank of Japan. A significant part of this liquidity has come to equities.

Shah of BNP Paribas says markets will continue to remain volatile till there is uncertainty. "India gained due to the global rally but global money is not going to come too soon to India as our economy, as well as spread of Covid-19, is yet to stabilise. However, we are better off today than a month-and-a-half back, as we now have a better understanding of the situation. Yet, till some uncertainty remains, there will be volatility," he warns. He expects the Nifty to be around 11,000 levels in FY22. "But we are still worried about FY21. We got it (coronavirus) last, will recover last, and have limitations with regard to the stimulus," he says. Closer to FY22, he expects Nifty to trade between 9,000 and 11,000. "If we have a vaccine two to three months from now, everything will look better. Nifty can test 8,500 to 8,700 on the downside but we don't expect it to go below these levels as that was a panic reaction," he adds.

Chokkalingam agrees: "Fundamentals will take time and improve only in the latter part of 2021. If a vaccine is found or the virus is controlled in one or two months, things can look better." Till that happens, investors will be better off treading cautiously. Sinha says it is advisable to go for companies that are resilient and have good cash flows and balance sheets. "They have the ability to absorb shocks," he says.

Since the market keeps falling and rising, without any consistent pattern, Shah says, "Investors should buy the market on every 4 to 5 per cent decline from current levels. The fact is that there are pockets of opportunities across sectors. Large private banks look great. They have underperformed materially and are trading below historical valuations. They will gain market share and eventually do better than the sector. Tier-II consumer names look interesting along with Tier-II large-cap IT stocks," he adds.

Shah, however, is not very bullish on auto post the recent recovery but sees a rebound in premium two-wheelers and four-wheelers as middle class consumers will be the quickest to come back to the market.

Sharma has an altogether different piece of advice: "Investors should not think equities is the only place where they can make money. This year, gold is up 26 per cent and government securities are up 7 per cent. In contrast, equities are down 25 per cent. Equity is not the only mantra to make money," he says.

(Rashmi Pratap is Co-founder & Editor of

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