There is a strong possibility of mean reversion for valuation multiples
The Nifty is once again on its way to reclaim the 12,000 mark and is within touching distance of lifetime highs. On the other hand, the September quarter corporate earnings were disappointing, leading to renewed pessimism over earnings growth. At the macro level, there are plenty of concerns about the country’s economic growth, but at the same time many stocks are breaking through all-time highs.
This rally, for sure, is keeping investors scratching their heads! While some worry about a melt-up, others wonder why the stocks are hitting record highs. Hopes have been kept alive by the government’s promise of reforms, but it remains to be seen if the market can manage to hold on to current levels in the days to come.
Nifty multiples are at all-time highs
The trailing price-to-earnings (P/E) multiples for the Nifty index is hovering at 26.8, which is the highest in the past 20 years. In the last 5 years, the index has risen nearly 40 percent and this rally has been mainly driven by liquidity and domestic fund flows. The index multiples have surged as stock prices have gone up despite the fact that earnings, for the Nifty pack, have seen annualised growth between 5-6 per cent over the same period.
Since 2000, the price earnings ratio for the NIFTY 50 has averaged around 20 times and it had gone down to lows of 12-13 times during the bear market of 2008.
Price-earnings multiples rise despite low return ratios
The price-earnings (PE) multiple in isolation does not make sense and should be seen in the context of growth prospects and return ratios. A combination of high growth and high return ratios augurs well for the equity markets and results in a multiple re-rating. The opposite also holds true during periods of deceleration. For instance, the Nifty had a major multiple re-rating between 2005 and 2007, a period that had strong revenue & earnings growth (20 percent plus) and improving return ratios. However, the multiples corrected in 2008/09 as the global economy slumped after the financial crisis and revenue growth for the Nifty pack fell back.
It is evident from the chart that the index movement has a high degree of correlation with the return ratios and both of them usually move in tandem. But the chart shows a divergence between the valuations and the return on equity in recent years. This divergence between the two is perplexing investors, as the index is moving higher amidst sluggish growth and declining return ratios.
Nifty 50 revenues declined in Q2
Indeed, the Jul-Sep 2019 period was one of the weakest quarters for India Inc. in recent years as aggregate sales of Nifty 50 companies declined more than 2 percent year-on-year. The operating performance was also subdued as easing of commodity prices (across most sectors) failed to propel EBITDA (earnings before interest, taxes, depreciation and amortisation) growth, which touched multi-quarter lows of 2 percent in Q2 FY20. Credit growth dropped to 6 per cent in the July-September quarter owing to risk aversion by NBFCs and banks. Given the slackening demand and weak data prints, India’s Gross Domestic Product (GDP) growth is anticipated to slip to 4.2 per cent in the September quarter.
Mean reversion on the cards
The rising index levels suggest that investors are hoping for a V-shaped recovery, but that appears unlikely as the economy is floundering due to the broken credit cycle – which cannot be fixed overnight. Demand concerns are intensifying due to lack of credit and commentary from company managements do not suggest an imminent recovery.
The economy is facing multiple challenges. On the domestic front, manufacturing is contracting, inflation is rising and consumer spending is faltering. On the international front, the global economy is weak. Growth across many countries continues to fade, despite monetary easing by central banks. In the US, the economic expansion which started in 2009, post the Lehman crisis, is now more than 125 months old and is arguably the longest in history.Given the lack of earnings growth and current valuations, there is a strong possibility of mean reversion in the index multiple. Investors should stay defensive and brace themselves for high market volatility and deep corrections in the days to come as the ability of such high valuations to be sustained could be tested in a weak demand environment.