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Sensex at 50,000: Warning signs of an overheated market

Most economic data points and indicators show that Indian stock markets are overheated

Illustration by Siddhant Jumde Illustration by Siddhant Jumde

Very often, headline numbers do not divulge too many details. To let the numbers do the talking, it is important to dive deeper. Also, it is difficult to accurately estimate any measure without studying its long-term trend and comparing it with other relevant indicators. Business Today looks at some such indicators such as price-to-earnings (P-E) ratio, market cap-to-GDP ratio and corporate fundraising to gauge market sentiment and portray the state of the economy.

Fundamental statistics such as P-E ratio are popularly studied in two forms, trailing and forward, to determine the valuation of a stock or an index. Trailing P-E is calculated by dividing the current market value by earnings per share over the previous 12 months. Forward P-E looks at a company's likely earnings per share for the next 12 months. Asset allocation trends in terms of cash and stocks attempt at measuring the risk appetite of investors. Further, the growing disconnect between the market and the economy is captured in the market capitalisation-to-GDP ratio. The miserable state of the economy due to lacklustre investment and consumption, and some visible green shoots due to the growing contribution of corporate earnings in quarterly GDP, have also been looked at. Last, but not the least, the pandemic year was defied by record high corporate fundraising, on softer interest rates.

Sensex P-E: Trading At A Premium

This index valuation metric is trading at a multiple of 32.9, significantly higher than its five-year trailing average of 23.5. Among its constituents, almost three-fourth are trading above their long-term average.

The measure: This is nothing but a reflection of the individual P-Es of Sensex constituents. Typically, a range between 25-30x is considered expensive, but that should always be used within context. A trailing P-E is expressed as the ratio of stock price to its earnings per share, or EPS. In this case, price per share is derived by dividing the combined free-float market cap of all the 30 index constituents by their total outstanding shares. Similarly, EPS is calculated by dividing the aggregate earnings of all these stocks by their total outstanding shares.

And its implications: Most valuation multiples are trading at a premium suggesting that valuations are expensive. "It is mainly due to overwhelming liquidity from central banks and better-than-expected pick-up in the economy, which has led to increased investor interest. Low interest rates have also aided flow into equity markets," says Ajit Mishra, Vice President, Research, Religare Broking. He believes markets could consolidate after a sharp run-up, and that would be healthy. Maintain a "bottom-up" approach (focussing on individual stocks) and invest only in fundamentally sound companies. Also, invest in a staggered manner, he adds.

Emerging Market P-E: Priciest Among Peers

On a 12-month forward basis, this comparative valuation metric is trading around a P-E of 24.2 (Nifty), compared to 13 for Brazil and 14.3 for China, making India one of the most expensive markets vis-a-vis other emerging ones. The country received huge inflows, close to $16 billion, between December '19 and November '20 from foreign portfolio investors, unlike many other emerging economies, where they turned net sellers.

The measure: Forward P-E multiples are considered for some emerging economies to identify how expensive or cheap India was compared to them.

And its implications: Expensive valuations don't seem to bother overseas investors much; India's medium-to-long-term growth prospects are attracting inflows. "Timely measures taken by the government and the Reserve Bank of India (RBI) to maintain liquidity and resume economic activities have appealed to foreign investors. Better-than-expected quarterly results, improving macro-economic data, abundant liquidity and progress on Covid-19 vaccine front have further fuelled optimism. An increase in India's weightage by the MSCI in its Emerging Markets Index to 8.7 per cent from 8.1 per cent is one of the major reasons that boosted investor sentiment and led to fund flows in recent times," says Gaurav Garg, Head of Research at CapitalVia Global Research Limited- Investment Advisor.

Market Cap-To-Bank Deposit Ratio: Excessive Optimism

This risk appetite measure, which drives capital market's participation, is currently hovering over 100 per cent. When the lockdown measures were imposed in March, uncertainties about the pandemic led to a massive sell-off - the ratio fell below 100 per cent to around 70-80 per cent as investors gravitated toward conservative investments. However, steps taken by the RBI to infuse liquidity into the system gradually shifted stakeholders towards equity again.

The measure: This relative measure, of the BSE 500 stocks as a percentage of aggregate bank deposits, mirrors the risk appetite of investors. The asset allocation trends are guided by the level of distress or greed - investors resort to conservative assets or bank deposits when fear grips them, while market levels rise when optimism rules.

And its implications: Low interest rate is one of the reasons why markets are so bullish. "But the primary reason for this sharp rally is huge capital flows, which, in turn, have been triggered by the humongous liquidity created by the leading central banks of the world, particularly the Federal Reserve. Markets are not led by retail investors; they are the followers, not the leaders. Markets are led by institutional investors," says V.K. Vijayakumar, Chief Investment Strategist at Geojit Financial Services. Since the Nifty has bounced back around 80 per cent from its March lows and investors are sitting on huge profits, it makes sense to partially book profits and move some money into fixed income, he adds.

Market Cap-To-GDP Ratio: Brilliant Recovery

It increased from 79 per cent in FY19 to 56 per cent in FY20 and 91 per cent currently (FY21 estimated GDP) - above the long-term average of 77 per cent. The rally since June '20 has led to the highest market cap-to-GDP ratio since FY10.

The measure: Popularly known as the Buffett Indicator, this method compares the market cap of listed companies to a country's GDP to weigh if the stock market is under-priced or overpriced. It is a very broad-based top-down ratio and gives insights into the broader market level. It gives a sense of where the market is standing vis-a-vis the economy, explains Gautam Duggad, Head of Research, Motilal Oswal Institutional Equities.

And its implications: It shows that the market has recovered well from the lows of March '20, led by opening up of the economy, improved corporate earnings and supportive liquidity and interest rates, adds Duggad.

Fundraising By Corporates: Setting A New Record

Indian companies raised a record Rs 9.97 lakh crore through equity and debt in 2020 (as on December 21). Of the total, Rs 7.58 lakh crore was collected from the debt market and Rs 2.38 lakh crore came from the equity market; Rs 7,092 crore was mopped through the overseas route.

The measure: Corporates tap financial resources to usually expand or pare their debt and explore various options such as debt and equity, depending on their feasibility.

And its implications: "Looking at both equity and debt fundraising, one of the key drivers has been lower interest rate and the resultant liquidity. Corporates are raising record amount of money, the so-called 'Covid capital,' to create a buffer in case of any future crisis," says Pranav Haldea, Managing Director, PRIME Database Group. The equity break-up shows around Rs 26,611 crore was raised from IPOs, while another Rs 1.45 lakh crore was mopped up through QIPs and rights issue, in the year so far.

"Indices are trading at all-time highs, but there is a lot of pain in the economy, which is not getting reflected. Any unforeseen event or negative news flow can cause a correction in the secondary market, following which primary market activity will also slow down. At some point, interest rates will also start moving upwards, which will suck up the excess liquidity in the system," adds Haldea.

Gross Capital Formation-To-GDP Ratio: Anaemic Demand

After contracting by a record 47.1 per cent, year-on-year, in the first quarter, the gross fixed capital formation (GFCF) fell 7.3 per cent in Q2 FY21, its fifth-consecutive contraction, primarily led by an expected pick-up in consumption demand ahead of the festive season. Eventually, its share in GDP improved sequentially from 22.3 per cent to 29 per cent during the period.

The measure: The share of GFCF in the country's output is a reflection of investment demand in the economy. A higher share depicts enhanced activity.

And its implications: Rebound in investments delivered a pleasant surprise for the economy as India's second-quarter GDP fell 7.5 per cent, after shrinking a record 23.9 per cent, year-on-year, in the previous quarter. Though resumption of economic activity has been gathering pace, experts believe both consumption and investment demand are expected to remain tepid for a while.

Profits-To-GDP Ratio: Contribution of Growing Earnings

Aggressive cost-cutting initiatives led to a five-fold increase in bottom-line numbers of companies, on a sequential basis. This pushed the profits-to-GDP ratio to a 32-quarter high of 4.6 per cent, compared to a low of 1.2 per cent and 0.5 per cent in the previous two quarters. A gradual recovery was visible in the GDP numbers too, which grew at 23.2 per cent, quarter-on-quarter.

The measure: The ratio evaluates the contribution of corporate profits in economic output, since the performance of the corporate sector is also taken into account while compiling GDP estimates. For this, profits of all listed companies were linked to the overall GDP.

And its implications: A long-term trend suggests corporate earnings have lacked resilience as the ratio has seen some deterioration in the past. Meanwhile, there are some visible greenshoots, but the Indian economy continues to face downward pressures from the sustained spread of coronavirus, and will take some time to recover.

@nitikiran