ExplainSpeaking: Despite the fall, are Indian stocks still overvalued?

ExplainSpeaking-Economy is a weekly newsletter from Udit Misra, delivered to your inbox every Monday morning. Click here to subscribe

Dear readers,

Last week, the Reserve Bank of India released its latest Financial Stability Report (FSR). The FSR is published semi-annually and includes contributions from all financial sector regulators. It is the main document for understanding the current state of risks to the stability of the Indian financial system.

ExplainSpeaking regularly analyzes FSRs. Here is the link to the latest which was released at the end of December. The latest copy includes links to previous ExplainSpeaking articles on earlier FSRs.

What is the main conclusion of the last FSR?

Over the past decade, one of the major risks to India’s financial stability has been the high level of non-performing assets (NPAs) in the banking system. NPAs are just a fancy way of designating bank loans that go unpaid. As expected, if the level of NPA increases and/or remains consistently high, banks suffer from reduced profitability. When this happens, banks tend to be slow to make new loans. This, in turn, dampens economic activity across the economy.

To a large extent, a high level of NPAs, especially among public sector banks, has been one of the major reasons that have held back India’s economic growth in the pre-Covid phase.

However, the news on this front keeps getting better. In a nutshell, by March 2022, gross non-performing loans (GNPA) in the banking system had fallen to their lowest level in six years. You can read more about this issue by clicking this story as good as this editorial of The Indian Express.

But this week’s ExplainSpeaking will focus on the state of Indian stock markets.

There are three main reasons for doing this.

#1: In the last FSR, one of the main observations that caught everyone’s attention was the growing disconnect between Indian equity markets and the real economy.

“Boosted by the bull run in stock markets across the world, the Indian stock market surged on strong rallies with intermittent corrections,” the December FSR said.

Strong investor interest had sent price-earnings (P/E) ratios skyrocketing. As of December 13, the one-year price-earnings ratio for India was 35.1% above its 10-year average and one of the highest in the world.

“This reflects some disconnect between the real economy and stock markets,” the RBI report said.

It was true: on the one hand, the GDP growth of the national economy had been steadily decelerating since the beginning of the 2017-18 fiscal year and yet, on the other hand, the stock market was reaching historic highs.

#2: Over the past few weeks and months, just like several global stock markets, Indian stock markets have moved off their all-time highs (see chart 1.45).

Chart 1.45: Movements of Nifty 50 indices and global stock indices (January 2022-June 2022)

“Domestic equity indices made significant gains in 2020 and 2021, outperforming their peers on better growth prospects. Developments in 2022, however, destabilized market sentiments and increased risk aversion, with the war triggering a sell-off. In line with the ongoing corrections in the stock markets of major economies, Indian stock market sentiment turned bearish and saw negative returns, with the BSE Sensex down 11.6% and the Nifty 50 down 11.5%. between late December and June 16, 2022,” the latest FSR states.

So the question is: has the recent “correction” solved the problem of Indian stock markets being overvalued and disconnected from the realities on the ground?

#3: The third reason to look into this question is motivated by the remarkable change in the investor profile of Indian stock markets since the start of the pandemic.

The fact is that over the past few months, Indian stock markets have been buoyed by domestic investors even as foreign investors have increasingly deserted Indian markets.

“The fallout from global risk aversion sentiment triggered outflows from REITs (Foreign Portfolio Investors) in EMEs (or Emerging Market Economies), including India. After record inflows of Rs 2.76 lakh crore in 2020-21, Indian equities came under selling pressure from Foreign Institutional Investors (FIIs) for the eighth consecutive month to May 2022 with a total net outflow of Rs 1.3 lakh crore in 2021 -22 and cumulative net outflow of Rs 66,809 crore in April and May 2022. Sustained buying interest from domestic institutional investors (DIIs), however, supported the market, capping losses,” the FSR said (see graphs 1.46 and 1.47).

Figure 1.46: BSE Sensex and foreign institutional flows (February 2021 – June 2022)
Figure 1.47: Trends in foreign and domestic investment in the cash segment (November 2021 – May 2022)

In other words, if the markets are still overvalued, what is at stake is the interest of domestic investors.

“Individual investor participation in stock exchanges has increased significantly since the start of the Covid-19 pandemic and the registration of new investors on stock exchanges goes beyond metropolitan centers and major cities. From January 2020 to May 2022, the number of retail Demat accounts increased 3.4 times in Central Depository Services Limited (CDSL) and 1.5 times in National Securities Depository Limited (NSDL) (see graph 1.49),” says the RBI.

Figure 1.49: Demat accounts with custodians (January 2020 – May 2022)

“The number of retail investors actively trading on the stock market is also on the rise (see chart 1.50),” the RBI adds.

Chart 1.50: Trend in the number of retail investors trading on the stock exchange. (January 2020 – May 2022)

According to the RBI, several factors have contributed to more and more domestic investors turning to the stock markets.

“The decline in real returns from bond investments, the simplification of Know Your Customer (KYC) registration processes, the efficient use of digital technology and online account opening, the increased availability of customer information ‘Investment on digital modes and growing public awareness has fostered a broadening of the investor base, including new investors,’ states the FSR.

By the way, just when (in April) domestic stock markets began to fall, ExplainSpeaking explained why domestic investors are rushing where foreign investors fear to venture.

So, have the Indian markets corrected enough? Or are they still overrated?

This is an important question as more and more domestic investors are rushing to start investing in mutual funds through the Systematic Investment Plan (SIP).

However, there is no sure way to answer when it comes to stock market valuation. Typically, there are 3-4 key metrics (see chart 1.48) that are used to arrive at an answer. The latest FSR also did the same. Here is an explanation of the four measures used by the RBI.

Figure 1.48: Key indicators for understanding stock market valuations

#1: The price/earnings ratio over 12 months

The “trailing” PE ratio of the stock index is nothing but the overall value of the index divided by the “earnings per share” of all the companies included in that index. As the chart shows, the 12-month price-earnings (PE) ratio of the BSE Sensex has fallen sharply. At the 20.8 level in mid-June 2022, it is now “well above its ten-year average of 22.4”, notes the FSR (see chart 1.48a).

Chart 1.48a: ESB Sensex PE over 12 rolling months (June 2008 – June 2022)

In other words, the trailing PE ratio would suggest that the markets have experienced enough correction and are no longer overvalued.

#2: The “forward” 12-month price-to-earnings ratio

This is similar to the first metric, but instead of looking at the PE ratio based on past earnings, here we are looking at the “forward” PE ratio, which uses “expected” earnings (within the next 12 months).

On this metric, however, Sensex is still above (read costlier) its emerging and developed market peers (see graph 1.48 c).

Chart 1.48c: 12-month forecast PE multiples (as of June 15, 2022)

#3: The market capitalization/GDP ratio

This is also called the Warren Buffet metric because the legendary investor often uses it to assess whether a particular market is cheap or expensive. In simple terms, this ratio is obtained by dividing the total market capitalization (or monetary value) of all listed stocks by the nominal GDP of the economy concerned.

As Chart 1.48b shows that for BSE Sensex, this ratio is still well above the 10-year average, suggesting that the market is overvalued.

Figure 1.48b: Ratio of BSE market capitalization to GDP

#4: The Bond Yield to Yield Ratio (or BEER)

This is yet another way to see if a stock market is overvalued or not. Investing in bonds is the exact opposite of investing in stocks due to diametrically opposed risk profiles. Read this article to learn more about bond yields.

In BEER, the idea is to compare the return on bonds with the return on stocks. Stock performance is nothing but earnings per share divided by the stock price or overall index.

Thus, BEER measures the relative attractiveness of equities vis-à-vis their much safer cousins ​​(— bonds).

If the BEER value is above 1.0, it indicates that the stock market is overvalued. A value below 1.0 suggests that the stock market is undervalued.

As Chart 1.48d watch, BEER left its highs and even fell below its long-term average of 1.61.

Chart 1.48d: Bond Equity Return Ratio (BEER) [June 2012 – May 2022]There are two ways to look at this value. On the one hand, BEER has exited its recent highs and on the other hand, the ratio continues to be well above the 1.0 mark.

Ultimately, each domestic investor will make his decision because it is a question of valuation. Moreover, a high valuation does not necessarily guarantee a market decline tomorrow, just as a low valuation does not imply an immediate rise. But these measures help investors become aware of the risks and opportunities.

What do you think of the stock market valuation? Share your views at [email protected]

Stay masked and stay safe,

Newsletter | Click to get the best explainers of the day delivered to your inbox

About Alma Ackerman

Check Also

Winning numbers drawn in the game ‘Mega Millions’ | State

Country the United States of AmericaUS Virgin IslandsU.S. Minor Outlying IslandsCanadaMexico, United Mexican StatesBahamas, Commonwealth …