stock market news: Valuations are up… will profits keep pace?

The sensex hit 80,000 intraday on Wednesday, while Nifty is well over 24,000 points. Both flagship indices have returned nearly 25% over the last one year, creating wealth for investors and making India one of the hottest markets in the world. Keeping that on one side, the market is currently trading at 24.7x trailing earnings versus a 20-year average of 20.4x (at the 88th percentile). So, what has been driving the markets and more importantly, what’s next? The superior returns were triggered by a stable macroeconomic profile, improving corporate profitability as well as strong liquidity. On the macro side, fiscal consolidation, a focus on capital spends and moderating inflation have boded well for India. The recent GDP growth print of 8.2% was also a positive surprise for market participants.

From a corporate profitability point of view, from FY18’s low of 1.3%, India’s corporate profits as % of GDP have dramatically improved to 5.5% in FY23. Liquidity has been strong too, providing a cushion to the markets. In 2023, FIIs bought $21.4 billion, while domestic institutions bought $22.3 billion. The vast improvement seen in systematic investments into mutual funds is particularly heartening. SIPs —which stood at Rs 8,500 crore in FY20 — amounted to Rs 20,900 crore in May of 2024. Even as these numbers explain what has happened in recent years, the question still remains: what now? And what next?

Equity market returns are a function of three factors: Fundamentals, valuations and sentiments.

On corporate fundamentals, India is anchored by a strong combination of macro stability and improving corporate profitability. Key macro data points like electricity generation, bank credit, GST collections and steel consumption continue to point towards a healthy business cycle. Our reading point towards a recovery in the rural sector. Consumption has been the weak link in the macro composition. The consumer confidence index is currently hovering in the neutral territory, compared to it being negative over the last few years. This points to a gradual improvement in consumption demand.

Earnings for Nifty companies are expected to grow at a CAGR of about 18% between FY23-26, pointing to a robust growth outlook. As against this positivity, one needs to consider the vitiated global geopolitical environment and the general low-growth environment prevailing in major economies.

As such, valuations are the weakest link in the equation. At the current level of valuations, corporate earnings need to surprise us in the positive direction to provide comfort, which, in the near term, is questionable. A cushion for valuations can come in the form of a moderation in bond yields. The 10-year bond yield, which was approximately 7.5% at the peak of the current cycle, is at a level marginally below 7%.

Sentiment is a contrarian factor. If the sentiment among market participants is robust, that’s a trigger for investors to be cautious. And if the sentiment is pessimistic, that’s when they would want to be more bullish. Current data from the ‘equity sentiment indicator’ shows that investor sentiment is very bullish. This warrants caution in the near term. While there’s optimism over Indian corporates’ growth prospects and their potential to deliver on earnings in the long term, current expensive valuations and elevated sentiments mean that one needs to be cautious in the near future.

(The writer is head of equity, SBI MF)