Market at record high not in sync with current economic realities. Is it a reason to worry?

Domestic equities have been trading at their all-time high level lately even as the macroeconomic indicators have been flashing signs of stress and the COVID-19 pandemic remains a looming risk.

The market suffered sharp losses in March 2020 when the pandemic started wreaking havoc. The government announced a complete lockdown which brought the economic activities to a standstill. The sentiment of the market was shattered.

However, in line with the global peers, the Indian government and the RBI were quick to announce measures to support the economy and the market.

A massive influx of liquidity and steep cut in lending rates cheered the market which was reflected in the sharp jump in key equity indices.

Nifty has jumped 111 percent from its March 2020 lows while Sensex has clocked a gain of 107 percent.

Mid and small-caps have outperformed the frontline stocks. BSE Midcap has jumped 125 percent since March 2020 lows whereas the BSE Smallcap index has surged as much as 183 percent in the same period.

India’s gross domestic product (GDP) for the financial year 2021 contracted by 7.3 percent.

What is the picture now?

The market has been rallying in the calendar year 2021, barring small consolidations, while the second wave of COVID-19 has significantly dented the pace of the economic recovery.

Fitch Ratings has cut India's growth forecast to 10 percent for the current fiscal, from 12.8 percent estimated earlier, due to slowing recovery post-second wave of COVID-19.

Ratings agency CRISIL has revised its forecast downward for India's GDP, to grow by 9.5 percent in FY22 from 11 percent projected earlier.

Moody's Investors Service believes the Indian economy can clock a growth of 9.3 percent in FY22.

Retail inflation has started to move higher. In May, India's retail inflation came in at 6.3 percent. The inflation prints for June, which is expected to be released on July 12, may be even higher owing to a sharp uptick in the fuel prices.

Rahul Bajoria, Chief India Economist of Barclays India expects CPI inflation to rise to 6.7 percent in June, with core inflation moving up to 7 percent, a seven-year high.

Communicating its tolerance for high inflation will remain a challenging task for the central bank, Bajoria said.

India’s m-cap-to-GDP ratio has been volatile, touching 56 percent (FY20 GDP) in March 2020 from 79 percent in FY19. It has rebounded to 102 percent at present (FY22E GDP) – above its long-term average of 79 percent, said brokerage firm Motilal Oswal Financial Services in its report.

Moreover, the valuations of the market are above historical average levels. As per Motilal Oswal, Nifty trades at a 12-month forward P/E (price-to-earnings) of 20.2 times - a 7 percent premium to its 10-year average of 18.8 times. 12-month forward P/B (price-to-book) of Nifty is at 3 times, which is a 15 percent premium to its 10 -year average of 2.6 times.

The price-to-earnings ratio (P/E) is a valuation parameter that measures a company's current share price relative to its per-share earnings. And price-to-book ratio (P/B) is a company's current market value to its book value.

Should you be worried?

The economic indicators are expected to improve in the coming days as the COVID cases have declined sharply and restrictions have been eased. Besides, the government is aggressively increasing the pace of vaccination which is expected to bring the pandemic under control.

The rich valuation of the market is also not a serious sign of worry as most analysts and brokerages expect earnings upgrade which may sustain the valuation.

"While the Nifty is not cheap at current levels, it is not very expensive either, especially given the fact that we are in the early phase of a recovery cycle where multiples tend to be higher," said Jyoti Roy - DVP- Equity Strategist, Angel Broking underscored.

"As we are in the early phase of a recovery cycle there is a possibility of earnings upgrades down the line which will make Nifty valuations reasonable," said Roy.

However, policy normalisation by the central bank is a fact which may occur sooner than expected and it may roil the market sentiment.

While the US Fed has already said that at least two rate hikes are possible by the end of 2023, RBI has maintained to keep the rates low for a longer time. However, rising inflation may pose a challenge to the RBI and make it rethink its stance on the monetary policy.

"The RBI monetary policy committee might begin to express more concern over inflation at the August’s rate review. As the second wave ebbs and vaccination rate catches up on better supplies, the central bank is likely to outline normalisation plans for 4Q21," said DBS Bank in a report.

"Communication will be key to ensure financial tightness doesn’t front-run the intended speed of normalising policy, emphasising that normalisation does not equate tightening," it said.

The market has other short-term concerns, too, such as falling rupee and hardening bond yields, but in the long-term, the market is likely to scale fresh peaks as the economy looks set to clock rapid growth.

"While India is currently lagging developed markets, the return of global growth and private capex, structural reforms and continued pro-cyclical policy support bodes well for the economic recovery ahead," said a report from Edelweiss Wealth Research.

"While downside risks from the third wave, subdued credit and general sense of risk aversion remain, India’s growth story is expected to pick up significantly. In fact, Nifty FY22 earnings growth estimate stands at an impressive 42 percent," said Edelweiss.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.