ExplainSpeaking: Despite the fall, are Indian stock markets still overvalued?

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Dear Readers,

Last week, the Reserve Bank of India came out with its latest Financial Stability Report (FSR). The FSR is published biannually and includes contributions from all the financial sector regulators. It is the main document to understand the current status of risks to the stability of the Indian financial system.

ExplainSpeaking regularly analyses FSRs. Here’s the link to the last one that was released at the end of December. The last copy includes the links to previous ExplainSpeaking pieces on earlier FSRs.

What is the main takeaway from the latest FSR?

Over the past decade, one of the main risks to India’s financial stability was the high level of non-performing assets (NPAs) in the banking system. The NPAs are just a fancy way of referring to those bank loans that are not getting repaid. Predictably, if the NPA level rises and/or stays persistently high, then banks suffer by way of reduced profitability. When that happens, banks tend to go slow on extending fresh loans. That, in turn, holds back the economic activity in the broader economy.

To a great extent, a high level of NPAs, especially among the public-sector banks, was one of the key reasons holding back India’s economic growth in the pre-Covid phase.

However, the news on this front has kept getting better. In a nutshell, as of March 2022, the gross non-performing loans (GNPAs) of the banking system had declined to a six-year low. You can read more on this issue by clicking on this story as well as this editorial from The Indian Express.

But this week’s ExplainSpeaking will focus on the status of India’s equity markets.

There are three main reasons for doing so.

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

“Lifted by the bull run in equity markets across the globe, the Indian equity market surged on strong rallies with intermittent corrections,” stated the December FSR.

Strong investor interest had driven up price-earnings (P/E) ratios sky-high. As of December 13, the one-year forward P/E ratio for India was 35.1 per cent above its 10-year average, and one of the highest in the world.

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

This was true: on the one hand, the domestic economy’s GDP growth had consistently decelerated since the start of the 2017-18 financial year and yet, on the other, the stock market was notching up historic highs.

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

Chart 1.45: Movements in Nifty 50 and Global Stock Market Indices (January 2022-June 2022)

“Domestic equity indices had made significant gains during 2020 and 2021, outperforming peers on the back of better growth prospects. Developments in 2022 have, however, unsettled market sentiments and increased risk aversion, with the war triggering a broad-based sell-off. In line with corrections underway in stock markets in major economies, sentiments in Indian equity markets have turned bearish and have registered negative returns, with the BSE Sensex decreasing by 11.6 per cent and Nifty 50 declining by 11.5 per cent between end-December and June 16, 2022,” states the latest FSR.

So, the question is: Has the recent “correction” resolved the issue of India’s equity markets being overvalued and disconnected from the ground realities?

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

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

“Spillovers from the global risk-off sentiment have triggered FPI (foreign portfolio investors) outflows from EMEs (or Emerging Market Economies), including India. After record inflows of Rs 2.76 lakh crore in 2020-21, Indian equities witnessed selling pressures from foreign institutional investors (FIIs) for the eighth consecutive month up to May 2022 with the 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 interests from domestic institutional investors (DIIs), however, supported the market, capping losses,“ stated the FSR (see Charts 1.46 and 1.47).

Chart 1.46: BSE Sensex and Foreign Institutional Flows (February 2021 – June 2022)
Chart 1.47: Trends in Foreign and Domestic Investments in Cash Segment (November 2021 – May 2022)

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

“Individual investors’ participation in stock exchanges has increased significantly since the onset of the Covid-19 pandemic and registration of new investors on exchanges is reaching beyond metropolitan centres and big cities. During January 2020 to May 2022, the number of Demat accounts of individuals has increased by 3.4 times in the Central Depository Services Limited (CDSL) and by 1.5 times in the National Securities Depository Limited (NSDL) (see Chart 1.49),” states the RBI.

Chart 1.49: Demat accounts with Depositories (January 2020 – May 2022)

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

Chart 1.50: Trend of number of retail investors trading in exchanges. (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 on fixed income investments, simplification of know your customer (KYC) registration processes, effective use of digital technology and opening of online accounts, enhanced availability of investment information on digital modes and growing public awareness has promoted a widening of the investor base, including first-time investors,” states the FSR.

Incidentally, just around the time (in April) when the domestic stock markets started falling, ExplainSpeaking explained why domestic investors are rushing where foreigner investors are fearing to tread.

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

This is an important question because more and more domestic investors are rushing to start investing in Mutual Funds via the Systematic Investment Plan (SIP).

However, there is no sure-shot 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 has also done the same. Here’s an explanation of the four metrics the RBI uses.

Chart 1.48: The key metrics to understanding equity market valuations

#1: The 12-month “trailing” price-to-earnings ratio

The “trailing” PE ratio of the stock market index is nothing but the overall index value divided by the “earnings per share” of all the companies included in that index. As the chart shows, the 12-month trailing price-to-earnings (PE) of the BSE Sensex has fallen sharply. At 20.8 level as of mid-June 2022, it is now “well above its 10-year average of 22.4,” finds the FSR (see Chart 1.48 a).

Chart 1.48a: BSE Sensex 12-month trailing PE (June 2008 – June 2022)

In other words, the trailing PE ratio would suggest that the markets have seen enough correction and are no longer over-valued any more.

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

This is similar to the first metric but instead of looking at the PE ratio based on past earnings, here one looks at the “forward” PE ratio, which uses the “expected” earnings (over the coming 12 months).

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

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

#3: The market capitalisation to 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. Simply put, this ratio is derived by dividing the total market capitalisation (or the monetary value) of all listed stocks by the nominal GDP of the concerned economy.

As Chart 1.48b shows, for BSE Sensex, this ratio is still much higher than the 10-year average, suggesting the market is overvalued.

Chart 1.48b: BSE market capitalisation to GDP ratio

#4: The Bond Equity Earnings Yield Ratio (or BEER)

This is yet another way to look at whether an equity market is overvalued or not. Investing in bonds is the exact opposite of investing in equity because of the diametrically opposite risk profiles. Read this piece to know about bond yields.

In BEER, the idea is to compare the yield from bonds with the yield from equities. The yield from equities is nothing but the earnings per share divided by the price of the equity or the overall index.

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

If the BEER value is more than 1.0 then it shows that the stock market is overvalued. A value of less than 1.0 suggests that the stock market is undervalued.

As Chart 1.48d shows, the BEER has come off its peaks and even dipped below its long-term average of 1.61.

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

Eventually, each domestic investor will make up his or her mind because this is a matter of valuation. Moreover, a high valuation doesn’t necessarily guarantee a fall in tomorrow’s markets, just as a low valuation doesn’t imply an immediate surge. But these metrics do help investors become aware of the risks and opportunities.

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

Stay masked and stay safe,


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