“It was the best of times; it was the worst of times, it was the age of wisdom, it was the age of folly, it was the epoch of faith, it was the epoch of skepticism, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair...”
In a world reeling from a pandemic, the opening lines of Charles Dickens's novel A Tale of Two Cities—referring to the contrast between London and Paris, where anarchy ruled before the French Revolution—pretty much sums up the Indian economy and stock market.
Look at how ironic it is! While the economy had its worst year since independence, equity investors had their greatest year ever. The Nifty 50 index climbed 72 percent in FY21, despite India's GDP contracting by 7.3 percent.
Despite the pandemic's crippling effect on the Indian economy and businesses, the Indian equity market has been one of the best performers in the post-pandemic period. Global market capitalization (m-cap) increased by 44.3 percent to $110 trillion in the last year, while India's m-cap increased by 67 percent to $3 trillion. It presently has a 2.8 percent share of the global map, greater than its historical average of 2.4 percent. On the other hand, India's proportion of global GDP fell to a four-year low of 3.1 percent in FY21, down from 3.3 percent the year before.
As a result, India's stock market remains one of the most expensive globally, with the BSE Sensex trading at a trailing P/E multiple of 31.3x, about 20% higher than pre-pandemic levels. What goes up must, however, come down.
When Does The Party Come To An End?
Is there a bubble that's forming? Benchmark indices have been range-bound over the past month, indicating bull fatigue. Several economists remain bullish, predicting that the markets will continue to rise. They believe that stock valuations are no longer relevant. What matters to markets is incremental growth in corporate profitability and the monetary policies of the world's main central banks, particularly the Federal Reserve of the United States.
But there's a snag. It's not going to be a never-ending party. Inflation is the main source of concern in all emerging markets. Mexico has begun raising rates, Russia and Colombia are considering hiking rates, and India is one of the few countries currently discussing a dovish monetary policy. There could be an issue if the narrative shifts sooner than planned (before the first quarter of the next fiscal), and if inflation and oil prices remain high,” says Amit Shah, head of India equity research at BNP Paribas.
In June, retail inflation was 6.26 percent, above the Reserve Bank of India's 6 percent target, owing to increased fuel and food prices. “Until recently, no one has complained about higher pump prices,” Shah adds, “but they are now beginning to have an inflationary impact since demand is increasing.”
According to Dharmakirti Joshi, chief economist of CRISIL, rising global commodity prices, particularly petroleum, are increasing inflation risks. “While manufacturers are currently bearing a bigger share of growing input costs, if demand rebounds, these will be passed on to retail prices.”
Companies have already begun passing on rising input costs to retail customers; Maruti Suzuki, Hyundai India, and Honda Cars India, for example, have already altered pricing twice in 2021.
Following a boom in worldwide demand, the price of Brent crude has climbed by nearly 45 percent to $75 per barrel, up from $51.8 per barrel at the start of 2021. “Crude's resurgence... could have a long-term inflationary effect. Our third-quarter projection was recently released, and our global teams raised inflationary expectations for practically every country,” Shah says.
With the contraction of the economy, there are more risks.
However, inflation is not the only threat to the bull market. A combination of record-high values and a substantial likelihood of lower-than-expected GDP growth, as well as a hit to corporate profitability in FY22 as a result of the second wave of the Covid-19 pandemic, raises equity market downside risks in the coming quarters. “States would be wary of fully releasing anytime soon due to the potential of another wave and delayed vaccines. That's in contrast to the previous fiscal year when a mostly consistent and timed reopening sparked a strong recovery,” Joshi adds.
CRISIL has decreased its GDP growth prediction for India for the current fiscal year to 9.5 percent, down from 11 percent previously. The stock market, on the other hand, is optimistic about future corporate earnings.
According to Vinod Karki, head of the strategy at ICICI Securities, there are two ways to look at corporate results. “If you look at India Inc.'s overall profitability, it's coming off a two-decade low. Despite all the hurdles, the profit (after tax) to GDP ratio improved to 2.8 percent during the epidemic year, driven by cyclical,” he notes.
From a technical standpoint, earnings are rising from a low base, fueled mostly by corporate banks, metals, infrastructure, and telecom, all of which have recently suffered losses. “This trend will continue since earnings will normalize in many dismal sectors over the next few years,” adds Karki.
The Nifty's profits outlook for FY22 and FY23, according to Shah, is 14 percent -14.5 percent on average. And, while it appears that the market doesn't deserve the current multiple, it has been selective in the way stocks have rallied: sectors like IT and pharma are up, "while companies exposed to travel or tourism, restaurants, or discretionary plays, as well as consumer retail, have been underperformers," he says.
Risks of a Tantrum Taper
A pause or end to quantitative easing is another key concern. The amount of money pumped in by central banks to keep purchasing power in people's hands has been unprecedented. According to JPMorgan Chase, central bank balance sheets would have increased by $11.7 trillion in 2020-21, bringing their total size to $28 trillion at the end of the year.
That is the source of concern. What if the tapering starts sooner than anticipated? “It might be a shock tomorrow if they surprise the market by announcing an immediate end to quantitative easing. But we don't expect any surprises as long as their credibility is maintained,” Karki says.
What happens if the markets plummet or are correct? According to Shah, when the tapering begins, there will be an initial sell-off. “However, because it has been so widely disclosed, the impact should be significantly less than the 2013 taper tantrum.” Then there are the so-called "Black Swan" events. “I don't see a serious crisis occurring shortly. However, small-caps will suffer the most if the market crashes, followed by mid-caps, according to G. Chokkalingam, founder and managing director of Economics Research & Advisory.
Stock markets go through cycles, with small- and mid-caps outperforming large-caps (as is the situation currently) or large-caps outperforming small- and mid-caps (as was the case between December 2017 and March 2020).
Since the start of 2021, small-caps have beaten the Sensex by a factor of five. The BSE Small-Cap Index has increased by approximately 46%, while the BSE Mid-Cap index has increased by 28%. The benchmark BSE Sensex, on the other hand, is only up 10% year to date. “Whenever small-caps exceed the Sensex by a large margin, the following year sees a significant correction. This is because their relative valuation rises,” Chokkalingam explains. As a result, investors are more likely to take profits and exit the market.
“When profit-booking occurs in small-caps, liquidity quickly evaporates because most money is invested for the short term. This is especially true because investors with a one-year perspective typically invest in small caps, which receive very little institutional funding. As a result, the transition from highs to lows can happen extremely quickly,” Chokkalingam notes.
As of July 22, the BSE SmallCap Index is trading at a 63 percent premium to the Sensex and a 25 percent premium to the mid-cap index. It has a price-to-earnings ratio of 53, while the mid-cap index has a price-to-earnings ratio of 42.
The high headline P/E multiples, according to Karki, are due to meager earnings and losses sustained by many small businesses during the pandemic, often known as the loss pool in market jargon. For FY21, the loss pool contribution to an aggregate profit base of 7,600 crores in the Nifty Smallcap 100 index was a negative 53 percent (-53 percent), while it was -42 percent in the mid-cap market to an aggregate profit base of 32,300 crores. The contribution to the loss pool for the Nifty 50 index was only about 2%.
Shah says that small- and mid-cap stocks might face a steep fall in the "unlikely case of a crisis." This is because the valuation of second-and third-tier equities is heavily influenced by liquidity and investor mood.
Because most retail investors invest in small- and mid-cap stocks, they tend to book profits and exit as soon as possible. “Retail investors have made a lot of money... will many of these investors book some profit to spend on discretionary goods and services when the economy opens up?” According to Shah, if this occurs, the impact will be felt primarily in the mid-and small-cap segments.
Large-cap stocks, on the other hand, are unlikely to be affected, according to analysts. “If small-caps collapse by 40%, large-caps may fall by only 5% to 10%,” Chokkalingam says, adding that a drop in large-caps is possible because certain firms are selling at a P/E of 100, which isn't sustainable. For example, Avenue Supermarts (DMart) and Titan, two of India's largest retailers, are trading at P/E multiples of 188x and 159x, respectively, even though their revenues and profits, which have been stagnant for the past two years, are expected to be hit in FY22 due to the second and likely third wave.
NTPC is trading at an 8x P/E at the other end of the spectrum, while Power Grid is selling at only 10x FY21 profits. “Money flowing out of high-priced stocks can be used to buy lower-priced ones. As a result, Chokkalingam believes that the aggregate market capitalization of large-cap companies would not fall.
The Crisis Management Plan
There is agreement on what to do in the event of a correction. “If a crisis occurs, it will provide an opportunity for a bottom-up approach,” adds Chokkalingam. Instead of being influenced by macroeconomic and market cycles, bottom-up investing focuses on analyzing individual stocks. Before investing, investors should consider a company's fundamentals, management commentary, prospects, and business stability. Ideally, one should seek out industry leaders trading at a discount to the overall market's valuation.
Chokkalingam recommends using four filters, particularly for mid-and small-caps: management quality, companies with the least degree of leverage, no major pledging by promoters, and stocks that provide value comfort.
According to analysts, small- and mid-cap companies are possible acquisition or investment targets for global private equity and venture capital groups.
While there is no imminent reason for the markets to crash, Shah believes that it will be a buying opportunity if they do. “This is because, despite the second wave, India remains one of the world's fastest-growing economies. In addition, despite rising inflation, India's monetary policy remains accommodating.”
Those that invest at the top of a valuation cycle, on the other hand, have had a bad track record. Because the Sensex had plunged to a seven-year low of about 17x, and India's m-cap-to-GDP ratio had hit a decadal low of 55 percent in March 2020, the post-pandemic returns appear rich. This precipitous drop cleared the way for a V-shaped recovery in stock prices. All valuation measures are now at all-time highs.
Lower-than-expected corporate earnings in FY22, as well as an adverse risk-reward ratio for equity as interest rates increase and the rupee, depreciates, provide downside risks to investors. Given that no one expects central banks to take away the punch bowl in a hurry, even if the broader market doesn't break, the returns from equities won't be very juicy.
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