The Indian equity market has hardly ever had it so good. It is hovering close to its all-time high, having provided returns of 22 per cent so far this year up to July 31. The Nifty's price to earnings (P/E) ratio is in the 25-26 times range, very close to its peak of 28.5 in February 2000. Liquidity is gushing, with domestic and foreign investors pouring in funds. But why is this so? What worries analysts is that there is nothing in the prevailing economic scenario to justify such optimism. "The bubble is getting bigger and exuberance among investors seems to be going out of control," says Pramod Gubbi, MD and Head, Institutional Equities, Ambit Capital, a leading investment bank.
To some extent, the Indian market has taken its cue from its global counterparts. The Nifty is not the only market soaring - five other global markets on the MSCI Index for Emerging Markets have done even better than India this year, with returns between 29 and 45 per cent: Poland, Turkey, China, South Korea and Greece. Indeed, all the 25 economies included in it have delivered positive returns barring Russia, Pakistan and Qatar. So too, the 23 countries on the MSCI Developed Markets Index have all delivered positive returns between six and 41 per cent.
"The rise is a global phenomenon and spread across asset classes," says Gubbi. "It is due to rising risk appetite among global investors, a feeling that nothing will go wrong in the near future." The global volatility index (VIX) of the Chicago Board Options Exchange (CBOE) - or 'fear index' as it is better known - confirms this sentiment, dropping to a record low of 8.84 on July 31, beating the previous low of 8.89 on December 27, 1993. The US Federal Reserve's decision, at its meeting in end-July, to leave the benchmark interest rate unchanged, has further assured investors that no big upheaval was in the offing.
And yet the bull-run, in the absence of all-round buoyancy, is mystifying. "Earnings have been disappointing," says Gubbi. "Downgrades have been rising. The introduction of the Goods and Services Tax (GST) has had an initial dampening impact, which will be felt in the current quarter. The inflation rate doesn't suggest any economic recovery and the manufacturing purchasing manager index (PMI), for the first time in years, has contracted below the average." In July 2017, the Nikkei India manufacturing PMI stood at 47.9, down from 50.9 in June, the lowest since February 2009. (A PMI value above 50 indicates expansion and anything below it, contraction.)
Not everyone agrees that the market boom is completely out of proportion to the state of the economy. Some believe corporate performance having been mediocre, it can only get better in future and market sentiment reflects that. "Earnings are at bottom, and hence the chances of them rising are more than of their going down further," says Vikas Gupta, CEO & Chief Investment Strategist, OmniScience Capital, a Mumbai-based hedge fund. "We are not close to our peak in the equity market. The P/E ratio may be good and that is the one everyone follows, but other market indicators show that we are not in any bubble zone. In fact, the market is still undervalued."
He points to the Nifty's price to book value (P/BV) ratio, which is in the range of 3-3.5, noting that it is still some distance from its peak of six times the book value. Similarly, the overall return on equity (ROE) of Nifty-listed companies is currently 14.5-15 per cent, while the average Nifty RoE has been 19-20 per cent. The sale to asset ratio is around 60-66 per cent, while on a normalised basis it ought to be 80-85 per cent. "The price of stocks which currently look overvalued will seem undervalued," adds Gupta
But Gupta, too, asserts that investors need to be discriminating. "The state of the market is certainly not the sort where one can blindly invest," he says. "There is value in about 70-80 of the top 200 stocks. But there is also a lot of junk on offer - overvalued and overleveraged stocks - which should be avoided. There are also companies with strong balance sheets, which are cash-rich and earning fat margins, but which are not on the radar of market watchers." The challenge is to spot them. "Investors need to take a cautious approach but they should remain in equities," Gupta adds. "Our moderate risk profile clients have 35-40 per cent of their overall investment portfolio in equities, up from 25-30 per cent three months back." But Gubbi begs to differ. "Just because investment avenues are limited doesn't mean one should invest in equities," he says. "Getting below par returns from investing in bank deposits and debt is better than losing capital by going into equity."
There is general consensus, however, that the fate of the Indian market is now inexorably tied to global developments. "If there is a joint effort by the big central banks - such as the US Fed Reserve, the European Central Bank, Swiss National Bank and Bank of Japan - to tighten liquidity flows, markets will come crashing down," says Gubbi. "If the global liquidity tap dries up, local flows will also be affected as it doesn't take time for sentiments to turn negative." He believes investors should be comfortable entering the Indian market if it corrects by about 15 per cent from the current levels.