Stocks

Are stock prices slaves to earnings? Not in this rally

Kumar Shankar Roy | Updated on January 21, 2021

It is said stock prices are slaves to earnings. It is the profit performance of companies that drive stocks to appreciate. But as the Sensex touched the much-awaited peak of 50,000 intra-day on Thursday, one cannot help but repeat the cliché - This time it’s different.

Breaking down the Sensex’ 50K journey into 10k intervals shows that while the journeys from 10K to 20K and 20K to 30K were backed by profit growth for the index constituents, the jaunts from 30K to 40K and 40K to 50K weren’t matched by earnings expansion.

 

Hopes, however, are high that the earnings of Sensex firms will catch up over the next 12-24 months, justifying the premium valuation of the 30-share benchmark today.

In the time the Sensex moved from 10,000 to 20,000 between February 2006 and December 2007, a rise of 100 per cent, the Sensex companies expanded their combined profits by 74 per cent if we take into account the trailing 12-month earnings between the two dates. The profit rise was helped by a 72 per cent jump in sales.

Again in the December 2007 to April 2017 period, as the index moved from 20,000 to 30,000, a rise of 50 per cent, underlying companies outdid the price gains with an earnings expansion of nearly 59 per cent. Their sales in this period more than doubled.

But beyond the 30K mark, which encompasses the bull market in the last five years, the correlation between the price gains and profit growth considerably weakens. The 33 per cent climb by the Sensex from 30,000 to 40,000 happened at a time when the earnings of these companies were almost unchanged. The most recent 25 per cent jump in the index from 40,000 points to 50,000 points, saw a profit expansion of just 3.3 per cent.

Key factors

Two factors could explain this phenomenon. First, economic growth was already beginning to weaken when the markets hit the 30K peak in April 2019 and the 40K peak in short order by June 2019. This dampened earnings growth. Recall how the government had to stimulate India Inc through a sizeable tax cut in September 2019.

Then, the 40K to 50K journey happened at a time when globally Covid-19 pandemic brought economic activity to a complete standstill thanks to the stringent lock-downs. This crippled companies including the giants that represent the Sensex and led to sharp profit declines in the first quarter of FY21. But the second quarter saw a fairly sharp bounce-back in earnings helped by cost savings. A gush of liquidity on the back of ultra-low interest rates, led to equity markets recovering sharply in the last couple of months on hopes of an imminent economic and corporate profit recovery.

At this moment, Indian markets are betting big on an all-round earnings recovery. The trailing 12-month earnings per share of Sensex firms is ₹1,436. Analysts expect the number to touch ₹2,200 next year, and ₹2,685 the year after, underlining the optimistic expectations that have been baked into the numbers. If the Sensex indeed delivers on this front, this will help pundits justify the forward valuation (price to earnings) of 18-22 times for the Sensex compared to the trailing PE of 34 times now.

Published on January 21, 2021

Follow us on Telegram, Facebook, Twitter, Instagram, YouTube and Linkedin. You can also download our Android App or IOS App.

This article is closed for comments.
Please Email the Editor

You May Also Like