Summary: In this note, we debate on the current levels of the Indian markets, using several well-known ratios, in the context of local and global events. We are perhaps continuing from my previous Outlook article – Equity Outlook, Nov’20: Rising like a Phoenix from the Ashes

Introduction

• The Markets are at an all-time high as Nifty crossed 17,000 levels and Sensex 58,000 levels. However, the Indian markets have been quite volatile in the last 2 years.
• In this note we try to debate and understand the causes and effects, and if the markets are Overvalued or Undervalued at these levels.
• Here are 20 year and 2 year charts of Nifty. Over 20 years, the Nifty has gained at 15.4% CAGR. Fig 1.
• In Mar’20, the market fell sharply by 39% due to Covid fears, but recovered thereafter See Fig 2.

PROS: Reasons why the Indian Stock Market is Overvalued

1. The Covid pandemic has affected the Indian economy, yet the markets are booming.

• The GDP growth in FY21 was -8%. In the second wave of May-July this year too the social and economic impact was hard. Inspite of this, the stock markets have risen. So, until the economy recovers, markets certainly look overvalued.

2. High P/E ratio of Nifty, as well as Midcap and Smallcap indices

• PE of nifty was recently as high as 42 times, and even today at 28 times means that investors are paying ₹28 for ₹1 of earnings. See Fig 3. Before the 2008 market crash, Nifty PE ratio was 28.29.
• Historically, a Nifty PE ratio of more than 25 means the Indian market is overvalued. 
• Due to pandemic, there has been a fall in earnings of companies, even as the stock market rose. This was one of the main reasons why Nifty 50 touched life time high. For example, Reliance Ind. and TVS have shown steady growth but there has been a steep fall in earnings of companies like ONGC, Maruti Suzuki etc. which caused a large increase in Nifty PE ratio.
• Cash influx by FIIs. During the pandemic, Central banks of USA and Europe printed cash in trillions as stimulus. The US Fed reduced interest rate to as low as 0.25%. FIIs started investing some of the cash in emerging markets like India for growth opportunities.

3. Market Cap to GDP Ratio

• This ratio is sometimes referred to as the Buffet indicator. It is a good way to check if the market is overvalued or undervalued compared to its past historical average.
• Historically India’s Market cap to GDP ratio is 75%. A ratio of 100% is a sign of an expensive market.
• Before the stock Market crash of 2008, the market cap to GDP was 103%.

4. Stock Market in a Bubble

• In India, investors seem to be in a frenzy and attracted to the stock markets. Total Demat accounts have doubled in the last 2 years. What started as a hobby and pass-time during the lockdown, also encouraged by mobile apps by stock brokers, has grown into a massive wave. The IPOs are getting highly oversubscribed.
• According to RBI, prices of risky assets have surged across many countries and have touched record high levels during 2020-21 on the back of unparalleled levels of monetary and fiscal stimulus.
• The US Fed said the turn in market sentiments “following positive news on the development of and access to vaccines and the end of uncertainty surrounding US election results” were some of the major factors that led to increased valuation of global equities, also reflecting in Indian markets.
• This asset price inflation in the context of 8% contraction in GDP in FY21 poses the risk of a bubble.

5. Debt to GDP Ratio

• The central govt. total debt/ GDP at end of FY21 was 58.73%. High ratio indicates that the market is highly leveraged. During 2008 the ratio was highest and was 58.86%.
• In a similar way, India’s total public debt (Centre and States) is likely to touch 90% of GDP in FY21, the highest ever recorded. In 2019-20, the total public debt to GDP ratio was 70%.

6. Nifty Price to Book Value

• It is the proportion of price to assets you own when you buy shares of a company.
• The average long term Nifty PB is 3.5. Majority of the time, Nifty PB stays in the range 2-4 range.
• It hit a peak of 6.55 during 2008.

7. The monetary and fiscal stimulus has to end, followed by Global Tightening

• With some recovery, the Fed and other Central Govts. have to draw back on the easy liquidity, raise interest rates, and the Indian stock markets will crash.
• This is a likely scenario, but we cannot say if this will happen in the next quarter or next 4 years.

CONS: Reasons why the Indian Stock Market is still Undervalued

1. Reforms in the Indian Economy

• A series of reforms in the last decade such as IBC, RERA, GST, crackdown on Black Money and investments in Digital and Fintech have happened and the benefits of these are unfolding.
• Growth initiatives like ‘Make in India’ and ‘PLI for manufacturing’ have set the stage for higher employment, reduced imports and a stronger economy and self-sufficiency.
• Govt. initiatives like controlling deficits, import substitution (in defense and monetization of gold assets) have strengthened the domestic economy.
• The Digital Transformation of Indian Stock Markets, and the fall from grace of Indian Real Estate for investments.

2. The China + 1 Situation

• The trade and political tension between USA and China has changed the equations in the last few years. USA had become dependent on China for a lot of manufactured products. With changing equations, it has become necessary for global firms to look at alternatives for manufacturing at scale. India is positioning itself as a good alternative by the Make in India and Production Linked Incentives (PLI) in manufacturing, extending from electronics, chemicals, defense, textiles, auto, etc.
• In capital markets, China recently cracked down on several domestic sectors like steel, education, ecommerce, fintech, etc. Many foreign investors lost money as the changes in business ground rules were sudden and unexpected and based on China’s authoritarian system. China may thus become an unattractive option for global capital, and India may emerge as a stronger alternative.
• These situations can result in India attracting high FDI and FII capital in the next few years.  

3. Because of Covid, many domestic sectors were affected, but are recovering fast

• Sectors such as Travel & Tourism, passenger transportation, Hotels, Restaurants, Auto, mfg., Real Estate & construction are sectors still below pre-Covid levels. Banks have also suffered. All these sectors are expected to recover in 1-2 years, which will help improve earnings of the sectors.
• The IMF has put India’s growth forecast as 9.5% for fiscal 2022 inspite of the second wave of Covid during Apr-Jun‘21. Chief Economic Adviser K V Subramanian said the economy is expected to stabilize to 8% growth in subsequent years.
• Strong economic growth will drive up the Earnings, and reduce the high valuations of the market. Already we can see that the Nifty PE has fallen from 42 to 29 in just 2 quarters as the economy improves earnings and recovers from Covid, see Fig 3.
• With better earnings, the high P/E ratio of Nifty, as well as Midcap and Smallcap indices will correct.

4. High Exports growth

• India’s exports are growing very well in the last few quarters, in sectors such as gems and jewellery, petroleum, chemicals and engineering. The indications are of an economic revival in India and the country is on track to achieve $400 billion of goods exports this financial year and attract high FDI in FY22.
• India’s foreign exchange position has strengthened in the context of the pandemic and India has been growing forex reserves at a record pace.
• The INR has strengthened in the last few quarters, while there was a broad decline in the USD after the Fed Chairman said more progress was needed in the economy to withdraw stimulus.

5. Covid fears reducing, and global economy in a rebound

• The second wave of Covid is receding in India. A third wave is possible, but we have already seen that the second wave was handled well by the administration and industry.  
• Vaccination is scaling up in India and should cover a majority of the population soon. This will allow free movement of people, a return to work, and ensure a rapid recovery of the economy.
• Post covid, the global travel will recover. Meanwhile in India IT based services and manufacturing are ramping up and supplying consumers in a global recovery.
• A massive migration of workers in India from Urban centers to villages, is slowly reversing as jobs beckon across construction, logistics and retail. Education centers and offices are also reopening.

• The high Market Cap to GDP Ratio may correct if the GDP rises as expected in next few years.
• The Stock Market appears in a Bubble but it is in fact recovering from many years of under penetration of equity and slow growth. A new generation of younger investors are more optimistic and positive in their thinking.
• The fiscal deficit would remain elevated over the next two years but the debt to GDP ratio is expected to stabilize or flatten out.
• The private sector has been underinvested in Capacity and Capex in the last decade. With lower interest costs and higher growth expected, the private sector is making capex plans. If the trend accelerates, the Price to Book Value will reduce.
• The stock market is forward looking. It anticipates higher GDP and growth in the next few years, and the Nifty levels reflect this optimism.

Conclusion

• As an investor in the Indian markets over the last 15 years, I have always believed in the growth story and the resilience of the market. At around $1947, the Indian per capita income is low. Given the freedom, global connects and govt. initiatives, the economy should be able to achieve over 7% GDP growth over the next few years. Except for the informal sector and unlisted space, much of this growth should translate into gains for the stock markets in India.
• The Indian economy has been reset by the Covid infection. However most businesses have been able to adjust and adapt to it in terms of prevention and resolution. It’s not business as usual any longer. The people and businesses are back, stronger than ever, and with a new urgency.
• Assuming a full recovery for the economy over the next year and good growth thereafter, the markets will stay positive. Given the context of excellent liquidity, low interest rates and a benevolent, growth oriented, stable policy environment, the Indian markets can continue to rise.
• Markets are unpredictable in the short term, but participants and investors can expect good returns in a 3-5 year period horizon.  

Disclaimer

This document has been prepared by JainMatrix Investments Bangalore (JM), and is meant for use by the recipient only as information and is not for circulation. This document is not to be reported or copied or made available to others without prior permission of JM. It should not be considered or taken as an offer to sell or a solicitation to buy or sell any security. The information contained in this report has been obtained from sources that are considered to be reliable. However, JM has not independently verified the accuracy or completeness of the same. Neither JM nor any of its affiliates, its directors or its employees accepts any responsibility of whatsoever nature for the information, statements and opinion given, made available or expressed herein or for any omission therein. Recipients of this report should be aware that past performance is not necessarily a guide to future performance and value of investments can go down as well. The suitability or otherwise of any investments will depend upon the recipient’s particular circumstances and, in case of doubt, advice should be sought from an Investment Advisor. Punit Jain is a registered Research Analyst under SEBI (Research Analysts) Regulations, 2014. JM has been publishing equity research reports since Nov 2012. Any questions should be directed to the director of JainMatrix Investments at punit.jain@jainmatrix.com.