Is the Indian stock market being remarkably prescient or simply foolish? The answer would depend on whether you are an optimist or a pessimist. Whatever it is, one thing is certain, recent market behaviour isn’t rational.
Friday’s action offered just a small indication of this. On a day which saw a virtual barrage of bad news on the macro front — declining manufacturing output, a dip in exports, a fall in auto sales and a spike in inflation — the Sensex latched on to a single bit of positive news, namely Infosys retaining its guidance, and gained 280 points!
One must allow for the fact that stock market movements from day to day seldom make sense. But then, the market has been rejoicing at random bits of good news and turning a blind eye to deteriorating fundamentals, for well over a year now.
The Sensex has rallied by 27 per cent between December 2011 and now. But the profits of Sensex companies have inched up by only 4 per cent over this period. In fact, profit numbers for Corporate India have consistently been 5-10 per cent below market expectations for the past nine quarters. The shortfall was the widest in the recent March quarter, at 12 per cent. Yet the markets have brushed this off and the Sensex is poised near the 20,000 mark.
Discounting better prospects?
The bullish faction of the market has several explanations for this divergence. The most popular one is that stock prices (as they always do) are discounting brighter corporate prospects in the years ahead. Though companies have delivered poor numbers in recent times, they will soon get back to double-digit growth, building on this low base.
But delving into the numbers of the listed companies, it isn’t clear what can trigger this rebound in profits. It can’t be robust demand, with sales growth for companies at 7 per cent in the latest quarter and losing speed. It can’t be savings in costs, with the weak rupee making inputs more expensive. Nor can it be lower interest rates, with rate cuts in remission.
In fact, even as this article was being written, analysts were busy trimming their profit growth targets for this year to factor in the recent bout of rupee depreciation. Remember, companies have already failed to match analyst estimates two years running.
Others point out that while earnings aren’t growing for now, stocks aren’t expensively valued compared to the long-term average. The Sensex has traded at an average price-earnings multiple of 15 times (forward earnings) in the last ten years. Therefore, current multiples at 14.5 times are comfortable. This means that the Sensex can head higher.
But the counter to this is: If corporate profits are growing at rates far below their long-term average, why should stocks enjoy multiples that are in sync with the long-term average?
It is something of an irony that the Sensex should be within a whisker of its life-time high, just after the economy has delivered its lowest growth in a decade.
And if prospects do improve, the improvement is likely to be gradual. Even the most bullish forecaster isn’t expecting GDP growth to rebound to 8 or 9 per cent within the next one-two years.
The disconnect between the Sensex and the situation on the ground is not just evident from the numbers. Meeting up with almost any listed company today leaves you with the sense that industrial activity is proceeding at a snail’s pace. Mid and small-sized companies are deeply worried about cost pressures, the risks from a sliding rupee and the difficulty with debt servicing.
Large, cash-rich companies are sitting tight on their surpluses, rather than deploying it in new projects. Banks are quite certain that their bad loan problems are set to get much worse before they get better.
Why, even domestic investors remain quite sceptical of this stock rally, a full two years into it.
Retail investors have been withdrawing money from equity mutual funds. Domestic mutual funds are choosing to hold higher cash positions or bet heavily on ‘defensive’ consumer or pharma names, as they get more and more expensive.
Normally, all this despondency would be the classic ‘buy’ signal for equities. Going by Warren Buffett’s tenet that one should be greedy when others are fearful, today, the mood on the Street is as fearful as it can get.
But the only problem is that, with the Sensex at 20k, stock valuations aren’t reflecting this ‘fear’ in any measure.
The best explanation for this divorce between domestic investors and the Sensex, is that the stock market behaviour now has less and less to do with what local industrialists or investors think or do.
With domestic investors consistently in ‘sell’ mode and foreign institutional investors (FIIs) mopping up shares, the FII stake in Indian markets is currently at a record high. At last count, they owned nearly 37 per cent of all equity available for trading.
Why FIIs have remained bullish on India despite the uncertain growth prospects and the string of earnings disappointments is hard to say. It could be that they have greater faith in the long-term prospects of the Indian economy than local investors do. It could be that, after taking stock of other markets, they still found India to be a good bet, relative to say, Brazil or Greece. Or it could just be that, flush with liquidity due to global easy money policies, they decided to temporarily park their surpluses in the emerging markets.
Whatever the reasons are, this situation puts Indian investors in a piquant situation. If they buy into stocks today, without waiting for an actual revival in economic prospects, they could face significant losses if companies continue to disappoint. If they stay away, and it turns out that the market was remarkably prescient, then they would have to get in at higher prices, effectively taking on higher risk.
What would neatly solve this problem would be a swift and sharp stock market correction that levels valuations and resets growth expectations.
At a multiple of 11 or 12 times, the risk of investing in Indian equities would be well worth taking. But it is the FIIs, again, which have the power to decide if domestic investors will get this opportunity.