The Economic Survey has sounded a caution note about the raging rally in the Indian stock market, which has outperformed many other major markets.
The Survey has raised the red flag over lofty valuations, fall in equity risk premium, and high expectations of earnings growth not yet playing out.
The 46 per cent surge in the BSE Sensex since end-December 2015, the Survey points out, is nearly the same as the 45 per cent rally in the S&P 500 index traded in the US. Also, both these bellwether indices now trade at similar high valuations, 26 times on price-earnings basis.
But the similarities end there.
One, the market rally in India has coincided with deceleration in economic growth in the country, whereas growth in the US has accelerated. Two, India’s current corporate earnings to GDP ratio has fallen to just 3.5 per cent while it remains a healthy 9 per cent in the US.
Finally, while real interest rate in India has risen sharply averaging 2.2 per cent over the period of the market boom, it has stayed in the negative zone (-1.0 per cent) in the US.
Despite these negatives, the rally in the Indian market, the Survey says, is due to two factors.
Moves against black money
The first is the much higher hopes of earnings growth, notwithstanding the miss on earlier expectations.
Next is the impact of anti-black-money policy moves such as demonetisation that have improved the attractiveness of stocks compared with assets such as gold and real estate that have suffered tighter regulations and weak returns.
Investors have reallocated their portfolios towards shares, especially through mutual funds that have seen a gush of record inflows. This, the Survey points out has led to a fall in the equity risk premium — the extra return required on shares compared with other assets — to just about 4 per cent in India now.
The Survey says that a sustained reduction in the equity risk premium is possible due to the portfolio shift towards equities triggered by the campaign against illicit wealth.
But it also points out to the experience in the US where the equity risk premium, after falling sharply in the early 2000s to about 1 per cent, rose to new heights (about 9 per cent in the wake of the global financial crisis) and at about 5 per cent now, still hasn’t gone back to its earlier lows.
Equity risk
The Survey also highlights that beyond the equity risk premium, the current high stock valuation in India will need future earnings performance to rise to meet still-high expectations.
This, in turn, will depend on whether a significant economic recovery is around the corner.
Otherwise, the possibility of a correction in market valuations cannot be ruled out.