In India, equity has performed well in prominent markets since 2015. The Sensex surged 46% in rupee value and 52% in dollar value. This triggered a sharp convergence of 26 percent in the cost-to-earnings ratios of the stock market of India and that of America. As per Economic Survey 2017-18, the economy of India and the economy of America have adopted different approaches.
In recent years we have seen that the interest of investors has shifted from gold towards equity. Keeping in mind the current trend, we shall explore the recent developments in the stock market.
The question revolving around the sudden convergence in stock markets has boggled many economists.
As per Economic Survey 2017-18, the track of Indian and American economies has parted in 3 striking ways.
First, the surge in the Indian stock market has concurred with a deceleration in the growth of the economy, but the growth of US economy has accelerated.
Second, India’s GDP has been falling ever since the financial crisis occurred around the globe. Currently, it’s just 3.5 percent, but the profits in the American economy are 9 percent of its GDP. Furthermore, the latest tax cut in America will most likely raise the post-tax income of Americans.
Third, the real interest rates have greatly diverged. In America, the rates have gone negative, while the Indian rates have increased. During the economic boom, America’s real rates averaged at -1.0 percent while India’s real rates averaged at 2.2 percent. This is a percent difference of 3.2.
The Market Convergence
As per the Economic Survey 2017-18, there are 2 factors behind this convergence. Firstly, the expectations of growth are high in India. In 2016-17, positive signs have emerged which signal that the fall in the GDP ratio is finally coming to an end.
Investors applauded this news by bidding up the share prices. As a result, the ratio of price to current earnings hiked sharply.
By FY 2017-18, it was expected that profit recovery is a distant dream. Another factor, i.e. demonetization added to the investor’s woes.
The cost of an asset isn’t solely affected by the return on the investment. It’s affected by the expected returns on different assets. As per Economic Survey 2016-17, the government’s fight against illegitimate wealth was represented by demonetization. Demonetization has imposed a heavy restriction on a few activities such as the stashing of cash, holding property, hoarding gold etc.
Furthermore, monetary transactions have been regulated. Information and documents required for acquiring property and gold have been tightened up. Additionally, stock prices were affected because of higher reporting requirements on shares as compared to any other asset. The fight against illegitimate wealth has offered a fair opportunity for everyone.
The recent developments have made investors re-assess the performance of stocks. Based on their performance, investors have reallocated their investment portfolios to shares. Now, stock mutual funds have more cash inflow. In the financial year 2016-17, mutual fund’s cash inflow multiplied by 5 times as compared to the inflow of the financial year 2015-16. As a result, the equity risk premium has also declined.
Does this mean that Indian price-earnings ratios have touched a higher “new normal”?
Maybe, yes. Most likely, the portfolio shift is triggered by the campaign (fight) against illegitimate wealth will cause a decrease in the ERP. In 1990-2000, a related assessment was made in America after its equity risk premium fell. After a while, the tech-bubble collapsed and gave rise to the financial crisis occurred across the globe. The equity risk premium increased and hasn’t maintained its preceding level.
Apart from ERPs, maintaining current stock value in our country needs future performance to fulfill high expectations. The results depend if a prominent rebound in the economy is likely to happen or not.
Furthermore, the survey stated that the surge in India stock market is differentiated from advanced economies in 3 areas- profit level & profit share, growth momentum, and real interest rates (R IR).
Low real interest levels have been evoked to substantiate the high valuation in the economies of developed countries. Our economy’s valuations are expected to be lower. Apparently, India’s valuations are driven by a dip in the ERP which is reflected in the portfolio re-allocation by investors towards equity due to policy-oriented reductions in the returns on various assets.
Wrapping it up!!!
Sustaining these evaluations would need economy as well as returns to grow and be in sync with the present expectations. Furthermore, the portfolio re-allotment should be semi-permanent in order to maintain the sustainability.