Over the last 10 years Indian Stock Market has brought phenomenal returns for investors. The BSE SENSEX index, also known as the S&P Bombay Stock Exchange Sensitive Index, consisting of 30 well established and financially sound companies in India has gained 355% over this period. Thanks to this record, Stock Market in India became the 8th largest in the world.
There are many signs, however, that in the following years stocks in India will not provide such a great returns.
Companies Profitability and Current Valuation
After the Global Financial Crisis in 2007-2009, stock markets across the world began their recovery. One probably would have thought that during the current bull market the best performer will be the stock market in the U.S.. However, as you can see on the chart, it was different.
Since 10 March 2009, BSE 30 Sensex Index increased by 355% in comparison to 333% gain of the S&P 500 – main U.S. stock index. In our opinion however, this rally is not going to last.
First of all, stock prices have significantly increased when at the same time companies earnings’ has barely improved. Earnings of 399 India’s largest companies have fallen over four out of five years, starting from 2015.
Thus, on average they have decreased 3.72 percent annually over a five year period. One of the reasons for such a development was the new government and its policies. Later on, also the introduction of a nationwide goods and services taxes on July 1 2017 had a negative impact hitting the economy and corporate profits. When we talk about the economy, we often reference to Gross Domestic Product (GDP). In terms of companies, however, it is worth to look at corporate profits to GDP ratio. For companies included in the Nifty 500 index, which represents 96.1% of the market capitalization of the National Stock Exchange of India, the ratio has been falling over the last 10 years. Currently it is 2.8 percent – 15 year low.
It is concerning because companies’ earnings are one of the main drivers of future investments and dividend growth. Therefore, corporate earnings growth is the foremost driver of the stocks’ gains. So we can expect that this deterioration most likely will be reflected in stock market performance.
We already wrote that stock prices increases and companies earnings are dropping. Then, it can not be a surprise that this phenomenon leads to higher stock valuations.
As as you can see in the third column Price to Earnings ratio (PE) is 28.8. This is the highest ratio among every stock market in the world. Table also includes other ratios, namely CAPE (10 year average Price to Earnings adjusted for inflation), PC (Price to Cash Flows), PB (Price to Book Value), PS (Price to Sales), DY (Dividend Yield). Based on all the above, India is the sixth most overvalued market on the entire planet earth. What does it mean for the future stock prices?
Above graph shows average (columns) and maximum (dots) possible drawdown for the particular stock market over the next 15 years, dependent on the current market valuations. As we ascertained already, Indian Market is considered as highly valued. Thus, as it is shown on the right side, there is a high probability that the market will experience approximately 35% average drop in the future. From the dots we can see that the drawdown can be as much as 73%. On the flip side, countries with attractive valuations may incur only 5-8% average drop, as it is shown on the left part of the graph. You can decide yourself which markets are more risky then.
So far, we have learnt about the stock market environment and current valuations. Now, let’s have a brief look at the present state of the Indian economy.
Economic data different than in reality
At the beginning, we want to emphasize that economic data releases across India should be taken with a pinch of salt. According to Reuters, 108 economists and social scientists have accused Indian government of interfering with the nation’s statistics-gathering agencies. To put it simply, there is a high probability that the government manipulates economic data. So how does the economy really look like?
From official statistics we know that, the Indian economy has grown at least 6 or 7% in nearly every year over the past 20 years.
As it is seen on the chart, that is almost double the growth achieved in its first 50 years as an independent state (from 15 August 1947). However, this is not reflected in the labor market conditions. Only less than half of the working age population is actually working or actively looking for a job. It means that more than half of the working age population (including 82% of all Indian women) are not included in official unemployment rate number. Thus, how you can actually believe that the jobless rate in the country is 3.5%? Of course it has to be much worse.
According to Monitoring Indian Economy, the unemployment rate in May 2019 was 7.17% versus 3.5% officially reported by the government. It means that the unemployment rate is at the highest level from 45 years. The graph below shows the number of unemployed people (in millions) in India.
source: Monitoring Indian Economy
It is clearly seen that the number of unemployed people in India has almost doubled over the last two years. Why is it important for the future stock market performance? High unemployment leads to lower consumer confidence and lower consumer spending. Due to lower engagement of consumers investment activities of corporates deteriorates what ultimately leads to lower corporate profits. It is proven by the chart below, which shows government and private capital expenditures (capex) in India in billion rupees.
As you can see, private capital expenditures has been falling over the 8 years, while the government spendings are increasing. Will this trend continue? In our view, it is highly likely.
Above arguments explain why this is not a good moment for investing in Indian Stock Market. It should be also added that from the psychological perspective there are also visible signs of euphoria. In 2018, equity investments share in India’s households has reached the highest level since a decade. Unfortunately, in the investment world it often happens, the so-called crowd (retail investors) put their money into the market in the latest stage of the bull market or economic expansion. The reason is clear: if everything is rising why it will not rise even more?
As you can see on the chart, equity saving as percentage of households assets in India is as high as in 2008. What has happened on the stock markets in 2008?
Both, the BSE 30 Sensex Index (blue line) and the Nifty 500 Index (green line) have reached their highs in January 2008, and in the subsequent months they lost 59 and 64 percent, respectively. We do not say that this for sure will happen again because the main reason for the drop was the Global Financial Crisis. We think, however, that there is not much room for further increases (after 10 years of expansion) and we rather invest in undervalued markets with much lesser risk of potential drops.
Independent Trader Team