The Great Stock Market Mystery
Rashmi Pratap November 25, 2019
On March 30, 1992, the BSE Sensex crossed the 4,000 mark for the first time. It took seven-and-a-half years to move up another 1,000 points past the 5,000 milestone on October 11, 1999. But the journey from 5,000 to 6,000 was a short one, less than four months. When Sensex hit the then all-time high of 6,006 points on February 11, 2000, India was well into the worst-ever economic slowdown. In financial year 2000/01, India's GDP growth hit a nine-year low of 4 per cent with the January-March quarter witnessing GDP growth of only 1.76 per cent. The farm sector was facing a crisis as production shrunk. In the next fiscal, growth in the manufacturing sector plummeted to 2.3 per cent, from 7.8 cent a year ago.
Cut to 2019. The Sensex touched a fresh all-time high of 40,816 on November 20. GDP growth hit a six-year low, rising only 5 per cent, in the April-June quarter. Private investment as well as government expenditure is shrinking. Industrial output or IIP contracted 4.3 per cent month-on-month (MoM) in September, the worst since the present series was launched in April 2012, while manufacturing output declined 3.9 per cent.
History is repeating itself, two decades apart. Surprising as it may seem, stock markets continued to scale new highs in both the cases, defying the gloomy economic indicators. "Fundamentals have been fairly weak since December last year. It has been nearly a year and this weakness has intensified in first and second quarters of this year," says Dhananjay Sinha, Head of Strategy and Chief Economist at IDFC Securities.
According to a National Statistical Office (NSO) draft report, household consumption in 2017/18 dipped for the first time in 40 years. The average amount spent by a person per month dropped to Rs 1,446 from Rs 1,501 in FY12. When consumption expenditure goes down, companies are impacted as their earnings fall and, hence, their capacity remains under-utilised, due to which jobs are cut and investments curtailed.
This sets in motion a vicious cycle where there is even lesser money in hands of people to spend, delaying consumption revival, which is necessary to boost corporate earnings and investments. Both are falling right now.
But then, why are the stock markets on fire?
'Hope Trade' Defying Gravity
Stock markets seem oblivious to the debilitating macroeconomic indicators. The Sensex and the Nifty have been on a roll since September 20, 2019, when Finance Minister Nirmala Sitharaman announced a cut in the basic corporate tax rate from 30 per cent to 22 per cent and for new manufacturing companies from 25 per cent to 15 per cent. The effective rate for companies came down to 25.2 per cent, including all additional levies, a benefit of nearly 5 per cent.
The very same day, markets witnessed the biggest intraday gain ever and the Sensex closed 1,921 points up, topping the 38,000 level. The Nifty jumped 570 points to end just short of 11,300.
In effect, the current market rally began with Sitharaman's corporate tax cut announcement and there has been no stopping since then. Markets continue to touch new highs every few days. The rally that was expected to end post-Diwali is continuing despite the deteriorating economic signals.
Umesh Mehta, Head of Research, Samco Securities, explains this by saying that the stock market is a forward-looking machine. "And stock prices reflect not what has already happened but what is expected in the next three to four quarters."
G. Chokkalingam, Founder and Managing Director, Equinomics Research and Advisory, agrees that stock markets discount the future. "The dichotomy (of dwindling economy and rising stock markets) is there because the market believes that things will improve in the short to medium term. It assumes that in 6-12 months, economic parameters will improve, corporate earnings will grow and that is why money continues to come in," he says.
In market parlance, this is called 'Hope Trade'. "There is also a lot of hope that the government will announce more sector-specific measures to ease corporate stress," he adds.
The rally in the benchmark indices, however, is neither secular nor broad-based. The benchmark indices, the Sensex and the Nifty, represent the strongest 30 and the strongest 50 firms' fortunes, respectively. These are companies that have delivered strong numbers despite the weak economic environment. Investors look for safe havens during bad economic cycles.
Dig deeper and the mid-caps and the small-caps tell a different tale.
The current quantum of fall in the mid- and small-cap space has been the worst in the last two decades. The combined market cap of Group B shares (mid-caps and small-caps) on the BSE fell 63 per cent from March 2018 levels; it had gone down 62 per cent post the Lehman crisis.
The current combined market cap at Rs 7.64 lakh crore is the lowest in the last one decade, indicating that this space has not benefitted from the current rally. "Mid-cap and small-cap stocks do not typically witness institutional participation and are very volatile. They may bounce back in 18 months if we go by historical evidence, though there is no rule," says Chokkalingam. This is because beyond a point, when large-caps continue to rally, they become so expensive that investors find them less attractive. "At that point, when any investor makes a significant move towards mid- or small-caps, the whole market jumps in their favour," he adds.
The performance of some large-caps has been aided by the reduction in the number of players in sectors such as aviation, media, non-banking finance and telecom. As a result, the surviving players have been rewarded by the stock markets for their robust business model and steady growth rates.
Ajit Mishra, Vice-President Research, Religare Broking, says the returns in the benchmark indices are largely skewed towards the outperformance of just eight to 10 heavyweight companies. "These companies remained the least affected by the slowdown and their continuous market share gains while maintaining profitability has led to their outperformance," he adds.
These top performers include NBFC giant Bajaj Finance, which has given 79.8 per cent returns (in the November 15, 2018, to November 14, 2019, period), followed by Bajaj Finserv at 62 per cent, Kotak Mahindra Bank at 37.5 per cent, Nestle India at 36 per cent and ICICI Bank at 34.8 per cent.
At a time when NBFCs are reeling under a liquidity crisis, Bajaj Finance reported a 63 per cent rise in net profit in the second quarter of the fiscal, led by growth in consumer, rural and mortgage segments. Given its top credit ratings and strong parentage, Bajaj Finance is among the handful of companies that have not only navigated the NBFC crisis successfully but are also among the stocks driving markets up every day.
Samco's Mehta agrees that the current rally has been driven by large corporations, which have remained unscathed or have felt minimum impact of the ongoing economic slowdown. "Indices reflect earnings growth and profitability during the quarterly results. This has led to concentrated buying patterns in indices, which has caused the bourses to touch all-time highs. This reality, though in contrast to the glum economic scenario, has led to the Nifty50 stocks moving higher," he says.
GDP numbers are largely representative of agriculture, manufacturing and services growth, which have their individual trajectories, says Mehta. While manufacturing and agriculture have not been encouraging, some pockets of services like banking and finance are showing quick recovery.
"GDP numbers are a larger reflection of economic activity as a whole, comprising the above verticals. But the stock market, in particular the Nifty, is moving on the strong delivery of quality companies as the Street is looking for safer havens for investment in these uncertain times. This has led to divergence between the bourses and the economy as a whole," says Mehta.
Mid- and Small-caps Trail
The divergence is not only between the bourses and the economy. Within the bourses too, mid- and small-caps have not been able to benefit from the current rally.
Since September 20, when the current rally began, the BSE Midcap Index has gained only 680 points while the small-cap index is up just 200 points, as per the closing on November 20. The Sensex has, however, gained over 2,000 points during the last two months. That explains why investors continue to flock to the large-caps.
The BSE Midcap index is currently valued at 27 times its underlying earnings in the trailing 12 months, a sharp decline from the price-to-earnings multiple of 35 times a year ago. In comparison, the benchmark Sensex is trading at 27.3 times its trailing earnings. This is the first time in over two years that the midcap index is trading at a discount to the benchmark indices that represent large-cap stocks.
Put simply, mid-caps are much cheaper than large-cap stocks in the current market. "The overall economic slowdown is visible in the mid-cap and small-cap spaces. Corporate earnings here are not showing encouraging growth. Only select large-cap stocks are performing and those are the ones where earnings growth is visible," says Siddharth Sedani, Vice President-Equity Advisory, Anand Rathi Shares and Stock Brokers.
U.R. Bhat, Fund Manager, Dalton Capital Advisors, says prices of small- and mid-caps are not as well equipped as large-caps to face any adversity in the economy. "So, they are quoting at a discount now after falling from peaks."
Another factor lending buoyancy to the stock markets is the ebbing trade tensions between the US and China. Globally, there is optimism that the first phase of the trade pact will be signed between the US and China, which may lead to rollback of tariffs announced earlier.
"This, coupled with signs of some green shoots emerging in the global economy drove capital flows into emerging market equities, including India. Despite India's weakening macro economy, buying interest in Indian stocks was largely fuelled by hopes of further reforms by the government," says Jitendra Gohil, Head India Equity Research, Credit Suisse Wealth Management, India.
IDFC Securities' Sinha says with both China and the US agreeing to scale down their stringent positions, the market sentiment has got a boost. "Also, indicators like auto sales and global trade numbers have shown that on a sequentially adjusted basis, there is an improvement along with bottoming out of stress."
It's not surprising that retail investors continue to be pulled towards equities as an asset class. According to data from the Association of Mutual Funds in India (Amfi), the assets under management, for the first time ever, touched the Rs 3 lakh crore-mark in October.
Even foreign portfolio investors or FPIs have been net buyers of Indian equities since September 2019, when the government announced tax cuts for companies. In October, their net inflows were Rs 3,800 crore, while in the first week of November, they infused a net of Rs 6,434 crore in equities in a boost to market sentiment.
"In the last four weeks (between mid-October and mid-November), the Nifty has risen 4.7 per cent, driven by net buying from FPIs, who have been net buyers. Hopes of more market-friendly announcements by the government and global risk-on sentiments have been fuelling the Indian equity markets," says Gohil.
No other asset class in India is at present delivering returns on the lines of the stock market, says Chokkalingam. "Real estate has been reeling under a slowdown, with some investors exiting the market even at a loss. Gold has lost its sheen. And that leaves investors with little option other than equity markets," he says.
But investors need to exercise caution while investing as all stocks are unlikely to provide good returns even though the broader indices are rising rapidly. "Investors should now go for only quality stocks and not try to catch sliding stocks where there are controversies or corporate governance challenges," says Sedani of Anand Rathi. Some mid-caps remain attractive in pockets that are showing value such as those in chemical and oil and gas sectors, he adds. "Yet, one has to be very selective in small- and mid-caps for another six to 12 months."
Corporates on Sticky Wicket
Caution for investors becomes all the more important because while markets have been regaining confidence, improvement in overall corporate earnings is a distant reality. In the first half of FY20, net sales of 2,398 BSE-listed companies were flat, showing growth of only 0.4 per cent. But more worrisome was the decline in net profit - it contracted 27.7 per cent over the first half of FY19. On a quarterly basis, net sales contracted 2.7 per cent in the September quarter, while net profits nose-dived 65 per cent.
One of the reasons behind this decline is the growth in the interest expenses of companies. Despite back-to-back rate cuts of 135 basis points by the Reserve Bank of India (RBI) since February, the lending rates have been hovering between 10 and 12 per cent for most companies. This reduced the interest coverage ratio for companies from 5.4 times to 4.8 times in the first half of this fiscal. This means the companies' ability to service debt weakened.
For companies, excluding those in the banking and finance space, the cost of power and fuel moved up, while depreciation jumped almost 24 per cent, in the first half of FY20. And for the September quarter, the mega losses posted by telecom companies have pulled down the overall profits of India Inc. The bankrupt Reliance Communications announced losses of Rs 30,000 crore while Vodafone Idea posted India's biggest-ever quarterly loss of Rs 50,921 crore.
Corporate earnings are expected to deteriorate as the benefit of corporate tax cuts could be largely offset by a sharp deceleration in GDP growth, says Gohil of Credit Suisse Wealth Management. "Nonetheless, hopes of further reforms and global risk-on sentiments are likely to keep equity valuations elevated."
The government has already announced a Rs 25,000 crore alternative investment fund for the real estate sector to bail out stalled housing projects in the affordable and mid-income segments. In August, it brought out a package to aid the auto sector by actively pushing government departments to purchase new vehicles and increasing the rate of depreciation to allow businesses to write off vehicles faster.
For the banking sector, Sitharaman announced an upfront infusion of Rs 70,000 crore in order to boost lending and improve liquidity. Housing finance companies were given an additional Rs 20,000 crore from the National Housing Bank (NHB). And the funding to NHB was increased to Rs 30,000 crore from Rs 20,000 crore.
"The government has tried to address various issues, including the NBFC crisis. I believe these measures have brought back some confidence to the market, especially on the housing finance side," says Sinha of IDFC.
But economists believe that only supply side measures aren't enough. "The government, besides measures like reducing costs, also needs to step up spend on rural infrastructure such as roads and housing and the Mahatma Gandhi National Rural Employment Guarantee Scheme to generate large-scale employment, which could stimulate consumption demand," says Sunil Kumar Sinha, Principal Economist and Director, Public Finance, India Ratings.
The central government's total expenditure (both revenue and capital) as a percentage of GDP has been declining since 2010/11. From 15.4 per cent of GDP in FY11, it has hit a low of 12.2 per cent of GDP in FY19. This slide is driven by the government's aim to check fiscal deficit, which has gone down from 4.8 per cent of GDP in FY11 to 3.4 per cent in 2018/19.
"An important factor is the slowdown in demand led by poor government spending," says IDFC's Sinha. The Centre for Monitoring Indian Economy (CMIE) said in January this year that fresh investment in the public sector had reached a 14-year low at Rs 50,604 crore in the December quarter of FY19.
Government spending helps the economy both directly and indirectly. The direct help is through employment schemes and subsidies, which gives more spending power to people. And indirect spending through projects to boost housing, agriculture and infrastructure development also improves demand and consumption.
While the government has announced various sector-specific measures and a cut in corporate taxes, economists believe it has not directly addressed the widespread weakness in consumption.
"The recent measures are likely to support growth only in the medium to long term. Also, as most of the measures aim to reduce the cost of goods and services, they are essentially a supply-side response to revive growth. The bigger challenge facing the economy is from the demand side as consumption has collapsed and private corporate investment is not forthcoming," Sinha of India Ratings adds.
Market experts are hopeful that the current levels can be sustained till the Budget is presented in February next year or the end of this fiscal. "Expectations are building up around the Budget and stimulus packages that may be offered. Markets will more or less remain around these levels till then. They can witness 400 or 500 points' volatility but no major correction is anticipated unless a big global news comes up," says Sedani of Anand Rathi.
While on one hand, further deterioration in the growth environment is expected to hurt corporate earnings, on the other hand, equity valuations could remain elevated given 'risk-on' sentiments globally (having an optimistic outlook or thinking that the market has not considered that outlook) and the expectations of further reforms by the government ahead of the Budget in early February, says Gohil of Credit Suisse.
Additionally, a better rabi season, and a 10 per cent above-normal monsoon, which is the best in 25 years, is expected to lift rural demand. "Water reservoirs are full and a good crop season is expected. There is hope for improvement in income and growth. So people will give at least six months' time for a turnaround. Beyond that, if there is no sign of revival on the domestic front or resolution of trade war (between the US and China), then things can get difficult (for markets)," says Chokkalingam.
Above all, GDP growth needs to perk up from the six-year lows and analysts believe that revival in consumption is key. "The need is to take measures that will enhance disposable income and put additional money in the hands of rural and urban households," says Sinha of India Ratings.
Clearly, the stock market has been pinning its hopes on a revival by the end of this fiscal. If the March quarter earnings point towards a revival and a turnaround, markets could continue to touch new heights. But if things don't improve, a downward slide will become a reality. Till then, markets will continue to hang on to hope.