The market surge makes Indian bourses most expensive globally

The unabated appetite for equities has taken the PE valuation of Indian markets sharply up, making them the most expensive among major developed and emerging economies.

At a trailing 12-month PE of 35.6 times, the bellwether Nifty 50 index is now at a steep premium to China’s SSE Composite (19.3 times) as well as the US’s Dow Jones Industrial Average (28.2 times). The valuation premium prevails when we consider earnings estimates for 2021 as well.

Besides, if one were to compare the relative attractiveness of equities based on forward earnings with the risk-free investment option — a valuation tool known as the ‘Fed Model’ — India is the only country where the equity index trades at a premium to the yield on the 10-year risk-free government securities.

In all other major economies, the equity indices trade at a discount to the 10-year risk-free government bonds. It is worth recalling that the US Fed Governor, Jerome Powell, recently referred to the ‘Fed Model’ to make a case for US equity markets not being in bubble territory as they were not expensive in relation to the risk-free rate. Under this model, in the US, the S&P 500, based on its 1-year forward earnings, trades at 70 per cent discount to the risk-free option. In contrast, the Nifty 50 trades at a 40 per cent premium.

Recovery priced in

While it would not be wrong to be optimistic on the Indian economy given the tailwinds of recovery from the Covid slowdown and many reforms being undertaken by the government, an expected recovery in economic growth need not necessarily translate into booming equity returns if the markets are already factoring that in, at the start of the phase. For example, while the Chinese economy expanded annually (CAGR) around 7 per cent in the last decade, its equity markets returned a CAGR of only around 3 per cent in the same period.

From end-2003 to the beginning of 2008, the Nifty 50 gave annual returns of 28 per cent when earnings grew annually at 17 per cent in the same period. High market returns were also a function of the fact that the Nifty 50 was trading at a PE of 15 at the start of that phase versus 35 times now.

Hypothetically, if the Nifty index was trading at 35 PE in end 2003, the returns would have been a mere 8 per cent CAGR till the beginning of 2008. Also, Nifty 50 earning for calendar 2020 is at the same level as in the last two years before 2020. Hence, there is no case of low-base inflating the Nifty PE either.

Takeaway for investors

Currently the market may have rallied predominantly on foreign portfolio investments. The Indian index may be relatively cheap for these funds coming from developed economies where the risk-free rate is near zero per cent. But that is not the case for Indian investors who get better returns on their safe investments. This apart, the money that has flowed in can reverse any time too. As veteran investor Jeremy Grantham says, “The one undeniable fact of investing is that, the more one pays for an asset today, the less will be the returns that can be extracted in future from it”.

Given that the Indian markets seem currently overvalued on many metrics, it will be prudent for investors to not put all their eggs in one basket. Diversification of the portfolio by also looking at international markets, with better risk-reward proposition, would be an option.

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