Stock markets may see sharp correction

There has been no reboot of the private investment cycle yet, and the beneficial impact of lower interest rates and lower inflation will only be visible with lags. 

The stock markets are bracing for fourth-quarter and full-year results. India Inc and the financial community don’t seem to be very optimistic in their projections. Consensus projections on earnings have been pared down. 

The value-oriented among the investment community are murmuring that valuations have run far ahead of the fundamentals in the past one year. The Nifty and the Sensex are trading at current price-earnings, or PE, ratios of about 22-23.

But earnings for the Nifty have grown by just five per cent in the same period. Expectations for the next fiscal year range from five-six per cent to 16-20 per cent. Indeed few analysts expect to see an acceleration in earnings growth in the coming few quarters.

For one, the global environment remains challenging — exports have fallen in the past three months and appear unlikely to drive the economy.

Additionally, despite India’s growth in gross domestic product, or GDP, being revised upwards, other indicators like spotty vehicle sales, low bank credit offtake and low goods traffic at ports and on railways suggest that domestic demand has not fully recovered.

True, macroeconomic indicators such as the twin deficits have improved; but there are few signs of that translating into higher investment or consumption yet.

Essentially, there has been no reboot of the private investment cycle yet, and the beneficial impact of lower interest rates and lower inflation will only be visible with lags. 

The market’s valuations have been buoyed, first by hopes of earnings growth acceleration in the second half of 2014-15 and then by hopes of acceleration in 2015-16. If those hopes are belied, with projections undergoing further postponement, the stock market may well be vulnerable to a sharp correction at some stage.

Dependence on inflows is also a problem. Foreign portfolio investors have bought about Rs 63,672 crore worth of equity since April 1, 2014, while domestic institutions have sold a net Rs 21,657 crore of equity in the same period.

The Nifty is up roughly 27 per cent in that period. Thus, this bull run was driven by money from foreign institutional investors, or FIIs, which have few other possible destinations given the parlous state of other large emerging economies.

Russia is suffering from recession and a currency crisis, Brazil and South Africa are in stagnation, Indonesia is struggling with high inflation, and China has revised its growth projections down to the lowest levels in 25 years.

Hence, most emerging market funds are overweight on India allocations. Any change in FII attitudes could trigger a significant fall. 

Worryingly, a correction down to more reasonable valuations would negatively impact deficit calculations.

The Union government’s Budget for 2015-16 has a revenue assumption of Rs 69,500 crore (Rs 695 billion) accruing from sale of its shares in public sector enterprises. Failure to meet this target could inflate the fiscal deficit.

And, of course, lower market valuations could make it harder for Indian companies to raise equity.

Given valuations and earnings projections, the government should strike while the iron is hot and get the disinvestment programme up and running. And it should be clear that reviving the private investment cycle will take more structural reform than it has so far undertaken.