Stock market indices Sensex and Nifty took a beating in Friday's trade amid renewed concerns over the looming US recession, following a weak set of jobless claims data in the world's largest economy. Analysts said domestic earnings growth is inadequate and valuations for the market are at risk. India’s valuations --absolute, breadth and relative -- are at extremes, à la 2007, said Nuvama Institutional Equities. At such valuations, five-year returns are likely to be subpar with risk of large drawdowns, it warned.
On Friday, the BSE Sensex fell 783 points, or 0.95 per cent, to hit a low of 81,084.77. The 30-pack index hit a record high of 82,129.49 in the previous session. The NSE Nifty tanked 227.95 points, or 0.91 per cent, to 24,782.95. Fear gauge India VIX, which suggests a likely volatility over the next 30 days, climbed 6 per cent to 13.71.
"Decelerating earnings and weakening US labour market (recession risks?) suggest an inflection point could be near. However, strong flows make it difficult to call a top. Our calls are relative with valuations now being the key anchor," the brokerage said.
While most market participants focus on PE multiples, Nuvama said PB and market capitalisation to GDP ratio (Buffett indicator) provide a better perspective for medium-term returns, as they smoothen earnings volatility.
Price to book value On a P/B basis, BSE500 is trading at 4.5 times – 20 per cent higher than pre-Covid level, but lower than the global financial crisis (GFC) peak of 6.5 times.
"The difference lies in the RoE profile. At the 2007 peak, BSE500's return on equity (RoE) was 25 per cent, whereas in 2018 it was just 10 per cent and today it is 15 per cent. Unless the RoE improves substantially, it is difficult to foresee a big re-rating," Nuvama said.
Buffett indicator In the case of Buffett indicator i.e. market cap to GDP ratio, Nuvama said India has just reached the previous peak of 150 per cent achieved in 2007. This variable best captures both primary and secondary market sentiments.
"In 2007, when the market cap to GDP hit 150 per cent – nominal GDP was booming in mid-to-high teens, but today it is barely even in double digits. Thus, from a real economy context, market valuations are quite excessive. Thus, when looking at absolute valuations they are close to historic highs, irrespective of the parameter one utilises. We also examine breadth and relative valuations to holistically understand market dynamics," it said.
Price to earnings The median trailing PE of BSE500 companies is at 43 times – nearly 2 times the median earnings growth. The level is substantially higher compared with anytime in the past. In fact, in the 2000s, the median trailing PE of a BSE500 company was around 20–25 times with nearly 40 per cent earnings growth, Nuvama said.
"In 2010s, valuations outpaced earnings, but were supported by low rates. Today PEG also looks very high despite higher rates. The story is similar when one looks at valuation from a P/B perspective. The median P/B is 6 times with median RoE of just 15 per cent. This is unsustainably high," Nuvama said.
Global market valuations What has been unique about the domestic market rally since March 2023 is that it is isolated from the world. Nuvama noted that cyclicals and mid caps have rallied only in India while In the rest of the world, they have been largely rangebound.
"Such decoupling is very unusual. While India does outperform EMs during bull phases, its meltup this time is quite unique," it said.
Earnings yield/BEER ratio If one looks at equity valuations relative to interest rates, then here too equities remain very expensive. Nuvama said the earnings yield minus bond yield gap both for India as well as relative to abroad remain close to the peaks seen in 2007. At such valuations, either growth needs to be very strong, or rate cuts need to be very large.
"If either of them are missing, then it is a cause for worry. Thus, even from a relative valuations perspective, aggregate valuations are at extremes, leaving little margin of safety," it said.
Cyclical valuations
If one looks at valuations from a sectoral perspective, then it is the cyclical pockets, which have lifted the aggregate valuations to such levels. Today, valuations of some cyclical sectors such as industrials, metals, autos and PSUs are close to historical highs while their premiums to the broader market are also at historical highs.
"Thus, from all aspects of the breadth of valuations, markets are at extremes and potentially unsustainable levels. In fact, on most parameters, valuations have perhaps surpassed the previous peaks, especially reached during the previous boom phase of 2002–2007," Nuvama said.