Market rally? It's driven by foreign money

From the valuation angle, the market is showing similar signs of being over-valued without being in a bubble territory yet, notes Devangshu Datta.

The Reserve Bank of India's (RBI's) token rate cut of 25 basis points was enough to send the markets soaring. 

The Nifty has risen 6.7 per cent, moving to a sequence of successive new highs. Every technical indicator suggests that the market will keep going up. 

It is impossible to set targets using trend-following methods. Other technical target-setting estimates are also liable to be totally inaccurate. 

The market is in a new zone and there are no obvious well-established resistances or supports above the 8,625 level for Nifty. 

While many technical indicators would suggest an overbought market, we know a strong trend can continue for months at a stretch, even as the market keeps indicating it is overbought.

Long-term benchmarks like the 200-day moving average (DMA) are way below the current level (the 200-DMA is 7,775-7,800). 

From the valuation angle, the market is showing similar signs of being over-valued without being in a bubble territory yet.

The Nifty is trading at a price-earnings (P-E) ratio of 22.5, using NSE's methodology of the past four quarters' standalone P-E, weighted by free-float weights in the Nifty. 

This is well above the long-term average (18.5) level but below the level where the index seems to have trouble sustaining prices. In historical terms, the Nifty has moved above P-E 25 during several stretches.

What is more, it would be a reasonable bet to stay invested even if the index went above 25; it hit P-E of 40 during the information technology boom of 1999-2000, mainly on the back of high-three-digit P-E ratios for IT firms. There is no way to predict a peak. 

There are a few points worth noting. One is that the rally has been entirely driven by foreign money.

Foreign institutional investors (FIIs) have net-bought equity of around Rs 5,500 crore in 2015, while domestic institutions have sold nearly Rs 3,000 crore. FIIs have also put over Rs 15,000 crore into rupee debt. 

Given the dimensions of the buying, FIIs presumably expect two things. One is that RBI will continue to cut policy rates, guaranteeing that debt holdings will benefit from capital gains.

The other assumption is that the rupee will maintain its value, mitigating currency risk.

The latter assumption is partly self-fulfilling in that the rupee is unlikely to depreciate much so long as there are portfolio inflows. The danger is that a rally sustained entirely by FII flow is also vulnerable to sudden cessation. 

Another detail is worth looking at. Earnings growth has consistently disappointed through the 2104-15. The Nifty has seen EPS growing at 14.5 per cent through the past four quarters using the same weighted free-float methodology. The PEG would be 1.55 which is well above the desirable valuation levels of one or less. 

So far, only about nine Nifty companies have come through with Q3 results. RIL, TCS, and Bajaj Auto have shown reduced EPS, while Hind Unilever has maintained reasonable returns only via extraordinary income.

Wipro also has single-digit EPS. The banks - Axis, IndusInd and Kotak have all seen excellent EPS growth however. Still, this set of results doesn't augur well since market leaders across multiple industry segments have not been able to deliver growth. 

It is true that stock market prices are driven far more by expectations of future profits than by historical or current earnings. But consistently slow EPS growth can eventually cause pessimism about future growth.

Balanced against that, there is a new Euro-denominated QE and that should ensure ample FII liquidity. There is also optimism that RBI will continue cutting rates and that the government will be able to deliver on reforms. 

The author is a technical and equity analyst.