EDIT: IRRATIONAL EXUBERANCE
It is hard to justify current market valuations
Awave of optimism has pushed the stock markets to new highs. The Sensex and the Nifty have hit record levels, and so have America's key indices, the Dow Jones Industrial Average and the tech-heavy Nasdaq. Going by the conventional metrics of valuation, the optimism is hard to justify. Indeed, it is driven by unusual factors. There is relief, given the favourable outcome of the first round of French presidential elections. If Emmanuel Macron becomes the next president of France as the opinion polls suggest, the European Union will survive. The euro jumped over 2 per cent on the election results. But a Macron victory is certainly not a done deal as yet. Extreme right-winger and Eurosceptic Marine Le Pen of the National Front remains in the fray. The second round of voting is on May 7 and, if Ms Le Pen does beat the opinion polls and win, a “Frexit” could well be on the cards. For that matter, Germany is due for elections in September and there are Eurosceptic right-wingers in play there as well.
Another factor that has enthused traders is Donald Trump's promises of deep cuts in US corporate tax rates, coupled with proposals designed to encourage US multinationals to repatriate profits generated and held abroad. But Mr Trump's record in office during his first 100 days as president does not bode well for his ability to either make coherent plans or to push them through Congress. His tax proposals are likely to be opposed by many members of his own Republican Party. There is also an inherent contradiction: Mr Trump wants a big push in infrastructure spending coupled with big tax cuts. If the cuts go through, where will the US government raise revenue to fund the expenditure?
In India, the economic growth rate is expected to accelerate. The promise of the goods and services tax (GST) is another strong driver for investors. Nevertheless, it is hard to justify current valuations by reference to projected growth rates. The Nifty, for instance, is a weighted index of the 50 largest listed companies in India and it is now trading at an average price-earnings multiple (PE) of about 24. But, the earnings growth rates are expected to hit 15-20 per cent in the best case scenario. Investors use a valuation metric called the PEG or PE to growth ratio where a company (or in this case, an index) is considered fair value if earnings are growing at the same rate as the PE. Thus, the Nifty would be considered fairly valued if earnings were growing at 24 per cent or ideally, even faster. The nominal gross domestic product (GDP) growth is expected to be about 11.75 per cent for FY18. But the Nifty contributes a large chunk of GDP and earnings are unlikely to grow more than twice as fast. In fact, among large companies that have declared their fourth-quarter results so far, only Reliance Industries has managed 13 per cent growth in net profits while IT sector giants — Infosys, Wipro and TCS — have all delivered single-digit returns and projections. The pharmaceuticals sector is also expecting dismal performances.
So, starkly in contrast to the exuberance in the markets, there are several potential pitfalls. Global growth could slow, given a rising tide of protectionism. Heightened tensions in Korea and the South China Sea could trigger unpredictable outcomes. The GST may take a while to settle. The Reserve Bank of India’s Monetary Policy Committee has cited upward risks to “core” inflation. However, away from such pessimism, traders look set to drive markets even higher as they selectively trade good news and ignore the bad. Needless to say, it is time to be cautious.