One parameter that is commonly used by traders and investors alike to monitor the ‘value’ of the broad market or the equity valuation is the price to earnings ratio also commonly known as PE. There is a number that the market participants call the equity valuation of the market is cheap and a number when they call it costly. Currently, the equity valuation of the market is in the costly zone.
The sharp rise in the market has brought the equity valuation to 28, a level that has been visited only three times by the market in the last two decades. No wonder then that there is a general inhibition in the market that it is overbought or that the equity valuation of the stock market is ignoring the fundamentals and running ahead of it.
It is at times like these that one is reminded of the famous economist John Maynard Keynes’ words when he said that markets can remain irrational longer than you can remain solvent. The stock market or the equity valuation of the market can keep on moving higher for much longer than most would anticipate.
In the current calendar year, the market has moved up by nearly 9 percent while it has posted a 17 percent return in the last one year. However, earnings growth during this period has been only 10 percent. This only proves the point that the equity valuation of the market has moved ahead of fundamentals.
But the market is known to capture the equity valuation of the future more than the equity valuation of the past. The earnings that we are talking of have already been reported by the companies and are reflected in the equity valuation of the market. What is now getting captured in the equity valuation is its future growth.
A look at the results in the recently gone quarter by and we would not be so sceptical about the market rally. Most companies have either exceeded the market expectations or have equalled it. The management commentary in most cases is that of a brighter future. Equity valuations of these companies are now factoring in these growth prospects.
To top it all the monetary policy report also spoke of strong growth in the economy. Capacity utilisations are high and so is credit off take. Most of the sectors are in the prime of their health. It is this growth that is reflected in the equity valuation of the market.
To add to that are the steps that have been taken by the government, especially in the rural economy where 70 percent of the country resides. This is the segment which has driven consumption growth now for nearly a decade, and with the current impetus looks good for the next decade too. The government has recently increased the minimum support price (MSP) of many crops which is expected to leave more money in the hand of the farmers. Equity valuations of companies dependent on rural growth are portraying the bright future.
The tax reforms introduced by the government in the form of Goods and Service Tax (GST) have started to show results. Tax collections are within kissing distance of a run rate of Rs 1 lakh crore per month. Higher taxes mean more money for the government to spend on infrastructure and other growth-oriented projects.
Banks, though not in the best of health have started to lend and have increased their focus on recoveries. Equity valuations of these banks are reflecting the changing times. Government too from its end has introduced many reforms and is open to capitalising banks.
Having said that, though the broad indices are touching new highs, there are few stocks that have participated in the rally. Many stocks, especially in the small and medium capitalisation space have fallen on account of many reasons but primarily on what has been quoted in media as regulatory over-reach. Thus one cannot generalise that the equity valuation of the stock market has moved ahead of fundamentals.
The other factor that is driving the equity valuations of the markets is strong fund flows. In the first half of the calendar foreign funds were selling in the emerging markets including India, but during these times strong domestic flows helped market absorb their selling and boost equity valuations. Off late foreign investors have turned buyers and have helped push the market.
While there are many headwinds to the market like rising oil prices, rising interest rates, higher inflation and trade wars, equity valuation of markets not only in India but across the globe have been ignoring it and The prime reason for global equity move is growth across the globe. Indian markets are no exception. Higher global growth means higher exports, higher employment, and higher consumptions.
The trade war is resulting in governments protecting their economies which in turn would mean higher employment. Though this would result in higher fiscal deficit and inflation, the problem would have been postponed to a future date.
The current equity rally is driven both by strong fundamentals and liquidity. Yes, the equity valuations are high but so is growth visibility. Further, we are not yet in the bubble equity valuation zone or to relate to Keynes statement markets are not yet irrational.
All negative news is getting discounted immediately and the market resumes its journey higher, which only highlights the strength of the market.