Nifty at 21k: Four solid reasons why you should not be worried about a correction

Stock prices are slaves of earnings. And India’s earnings growth is very much on track

Stock markets climbing a new peak may seem scary, but fears of steep correction may be unfounded. All bull markets climb a wall of worry, but you don’t make money if you get worried and refuse to ride the bull run.

With Nifty touching the psychological 21,000 mark, here are four reasons you should not be fearful about correction:

Continuity of administration

What sparked off the rally in Indian stocks this week was the BJP's decisive win in the assembly elections of three key states, which was a more positive outcome than what the markets were expecting.

The markets would have shrugged off a worse outcome in the assembly election placing its belief in the fact that voters generally tend to vote differently for central elections compared to state elections. But, the recent win only strengthens BJP’s case further, putting it in pole position for the general elections.

Also Read: Cheer on the Street as Nifty hits 21,000; gains 2% for the week

The belief that this administration has been able to navigate the tricky geopolitical situation deftly, and keep India firmly on the growth trajectory while keeping the fiscal position in check has inspired confidence among investors. The continuity of this government thus is inextricably linked to India’s growth story, thus the election outcome has been a key driver.

This rally has legs to run

Stock prices are slaves of earnings. And India’s earnings growth is very much on track. In fact, we may be simply underappreciating the earnings potential because for the past 10 years, corporate profits have been depressed because our banking sector was reeling under the weight of bad loans and we were caught in an investment downcycle.

Last week, in an exclusive interview with Moneycontrol, Morgan Stanley’s Ridham Desai reaffirmed this point. He said that India’s earnings cycle is now firmly on its way up and will be driven by rising share of profits as a percentage of GDP. He expects the share of profits in GDP to rise from 5 to 8 percent and the nominal GDP to grow around 10 to 11 percent. “If this happens over four years, then earnings would grow at 20 percent. But this happens over three years, earnings growth could be even faster.”

Also Read: Morgan Stanley’s Ridham Desai on what will drive 20% earnings growth over the next four years

Markets aren’t as expensive as you think

Most investors who think the markets are expensive, usually go with the index levels which do not reflect the ‘true value’ embedded in the market. The ‘value’ in a stock is the discounted value of future profits the underlying business is expected to make.

How do you assess this? You can do so by doing something called a reverse discounted cash flow. Simply put, you try and calculate what the current price of a stock is conveying about the profit growth for a company, and then see if this growth rate in earnings is achievable.

Also Read: India’s bull market is underpinned, it could be a 40-year story: Ridham Desai

A calculation done by Moneycontrol with data from Bloomberg shows that 20 percent of companies in the Nifty 50 reflected an implied growth of over 20 percent. 56 percent of Nifty companies showed implied growth of 10-20 per cent while 22 percent showed growth between 1-10 percent. This is not outlandish, considering that if we continue to see a GDP growth of 7% and inflation of 4%, we are talking about a nominal GDP growth of 11%. Now count in the fact that share of profits will grow because the investment cycle is still way below the previous peak and seem to be on an uptrend.

Foreign investors at decadal low

One can look at this as a glass half full or a glass half empty. Markets eventually regress to mean. Foreign investors were the first ones to push markets to greater heights after the steep correction during COVID-19. This move came on the back of the gush of liquidity that flowed into global equities as central banks around the world, especially the developed markets led by the United States, opened the floodgates with monetary easing and fiscal stimulus.

Also Read: Foreign investors to soon rush for India, time to look at largecaps, says Saurabh Mukherjea

This not only took the markets higher across the globe but also fueled inflation. To rein in inflation, the central banks across the world, led by the US Fed had to step on the brakes.

Fed hiking rates to the highest rates in 15 years, led to investors withdrawing money from riskier markets like India to ‘safer’ markets like the United States. If a global investor can get a 5.5 percent rate of return in the US with no risk, why should he or she invest in India? This kind of withdrawal led to a reversal in foreign flows pushing FII holdings to a decadal low.

Expectations are that this could reverse now. If inflation has been put behind as most economists suggest, and rates peak out and start to go down from here, foreign investors will come back into emerging markets like India which will once again lift stock prices. There are risks to this, but the belief is India's growth story is powerful and therefore foreign investors can not ignore it for too long.