Corrections and valuations

High valuations, scams, banking crisis and political uncertainty may keep markets subdued

On March 11, I had speculated that the stock market could be due for a steep correction (Refer to: https://goo.gl/46TJou). Conditions for a big trend reversal are visible, including very high valuations, scams, banking crisis, and political uncertainty.

A reader, “Ravi” disagreed and wrote a thoughtful comment, which is worth a response. Ravi’s points (edited for brevity) are given below with responses.

Ravi’s Comment 1: We are nowhere near the threefour years of robust corporate profit growth at the end of which excesses lead to a correction. In fact, we are just at the start of such economic growth.

Response 1: Bull markets often occur without strong earnings growth if liquidity is high. One example is the bull-run of 1991-92. Another period is January 2016January 2018 when Nifty earnings grew at 5.1 per cent compounded annual growth rate (CAGR), 10.5 per cent absolute, while the index rose by 24.4 per cent CAGR (55 per cent absolute). Also, we may not see accelerated growth starting now, given a banking crisis.

Comment 2: Not sure where the author calculated 100 times price-to-earnings (PE) valuation for small cap index as a whole?

Response 2: The Nifty Small Cap 250 Index PE is the NSE’s calculation. The PE for the SmallCap index 250 was 99.78 on March 22, according to the NSE.

Comment 3: Let’s assume a 50 per cent correction. The Nifty would come down to 5,500, which is lower than the previous bull market top of 6,300 in 2008. So, one complete cycle and the author suggests that the ‘aggregate’ corporate profits were lower than that of 2007? Not consistent either with reality or past history.

Response 3: Deep corrections are consistent with history. The market moves from over-valuation (above PE 23) to under-valuation (below PE 15). At its 2001 low, the Sensex was trading below its 1992 peak. (The Nifty was launched in 1994 and it also traded below 1994 values in late 2001). The market dropped by over 50 per cent between Jan-September 2008, 2000-2001 and 1992-93. Three other declines of between 40-50 per cent have also occurred between 1992 and 2018. That’s six declines of over 40 per cent in about 26 years.

Fair value right now (Assuming PE: Earnings Growth ratio of 1 is fair) would be 30-35 per cent correction from 11,170. NB: I did not suggest aggregate corporate profits were lower in 2018 versus 2008!

Comment 4: From 6,300 Nifty (peak was 6,357 on January 8, 2008) in 2008, to 11,000 Nifty in 2018 (peak of 11,171 on January 29, 2018), is a CAGR of 5.8 per cent and the author seems to suggest stocks reached extreme valuations? I fail to coherently understand this.

Response 4: Valuations are not the same as returns. The returns over 2008-2018 stood at 5.8 per cent CAGR. Valuations at the January 2008 peak of 6,300 was about PE 28. Valuations at the Jan 2018 peak of 11,170 was PE 27.5.

Comment 5: Where is the extreme initial public offer froth that typically exists at an extreme bull market top? The current crop of IPOs are at higher valuations but by no means exorbitant.

Response 5: It’s true that the primary market is not as over-heated as the secondary market.

Comment 6: The current correction is where some excesses are being corrected, and quality stocks are going sideways. We may see further price damage of no more than five per cent and the market may go sideways after which stocks will follow earnings growth, reacting to major news along the way. We are at least three-four years away from a full-blown bull market top.

Response 6: Taking the top 100 quality stocks – the deep blue chips of the Nifty and Nifty Next 50 - 86 scrips are trading below their respective January 2018 peaks. I agree that the next market top may take three-four years or longer. Where we differ in opinion is that I think that there will be a deep correction before that next peak is hit.

On March 9, when I wrote that piece, the Nifty was at 10,226. A five per cent correction would imply a bottom at 9,700. As of March 23, the Nifty is at 9,990. Only time will tell if it will fall further. I think it will for the reasons I cited earlier. But Ravi’s arguments are certainly worth consideration.