Share prices in India are soaring. Benchmark indices like the S&P BSE Sensex and NSE Nifty are at a record high. Analysts have predicted that they would scale peaks of 40,000 and 12,000 respectively sooner than later.
A lot of this predictive analysis is based on the hope of a stable government after the general elections.
However, we are staring at an imminent correction in the stock market. No matter what the election result.
Financial markets are evaluated based on technical and fundamental analysis. The technical study predicts a short-term to medium-term trend in share prices based on the historical trading data. The fundamental analysis predicts a medium-to-long-term trend based on the financial performance of the company in the past and more importantly an expected pattern in revenue and profits of businesses.
From an investment standpoint, fundamental factors matter. Most of you are ‘buy and hold’ investors. You want your investment to generate a steady return over the time you are invested in it. Many of you are wondering if you are missing out on the action when share prices are trading at a record high. This column suggests caution on the road ahead.
Valuation
Share prices follow the trend of the growth in profits of businesses. If companies generate steady revenue and profit growth, share prices will move up in tandem. There are many instances when share prices rally or fall due to reasons other than these. However, over a long period, share prices tend to follow the trajectory of the growth in profits — a key parameter to the price to earnings multiple. If one looks at the S&P BSE Sensex, it is currently at 27 times the earnings per share (EPS) of Sensex companies. The earnings per share of the Sensex is the aggregate of EPS of all 30 companies that make up the index. An EPS is the value you get if you divide the net profit of the company with the number of shares issued by it.
To put things in perspective, it is the highest at the end of past four government terms. In 2004, at the end of the term of Atal Bihari Vajpayee, it was 14 times. In 2009, when the UPA I ended the term, it was 16. By the time the UPA II tenure ended, the P/E multiple had expanded to 18 times.
The number 27 is a significant jump from the trend typically observed. That is because share prices have rallied way ahead than the actual profit growth of businesses. Over the past three years, the profit growth of the business as measured by the EPS growth is flat to negative. According to one analysis sent out by DSP Mutual Fund to investors, the compounded annual growth rate of profits is a negative 0.7 per cent for the five years to April 2019.
What pushed share prices up
It is clear that fundamentals currently do not justify the dizzy value businesses are getting. However, over the past five years, India has witnessed a sharp surge in foreign and domestic institutional inflows. While foreign flows have been stronger each year for a long time now, domestic flows have generated a significant liquidity flow into equity markets. These are due to systematic investment plans of mutual funds or insurance companies or pension and provident funds. The trigger for domestic flows was the sudden withdrawal of currency notes in November 2016. Since then, much money has chased too few companies. With more buyers in the market than sellers, share prices are scaling new peaks.
Two things have to happen. Share prices have to correct from where they are. That has got nothing to do with the election result. Currently, share prices are running way ahead of the fundamental value. They will sooner than later revert to a trajectory they typically follow of the profit growth. The other thing to happen could be a sharp bounce back in profits of businesses over the next two years. However, it is unlikely to bring the fundamental value to lower levels of the past.
What can you do
If you are looking to invest, you may want to wait for a market correction before allocating a significant chunk of your savings to equities. If you are already invested, ride through the imminent fall and invest more when share prices tumble. Do not panic and sell when share prices are falling.
A trigger for a sharp fall could be around the corner with election results due on May 23, 2019. From the trend witnessed in the past, one can say that if the election result is unfavourable to the liking of the stock market, share prices may fall sharply on the election result day.
Even if a stable government is elected, share prices may correct if profit growth continues to disappoint.