market valuation: Valuation worry? Have to live with higher mcap-to-GDP, PE, PBV now

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Stock markets globally have rebounded sharply towards their pre-Covid levels. Technology, pharma and IT have been a big gainers in the Covid situation and tech-heavy exchanges, Nasdaq (US) and Shanghai (China), are at all-time/yearly highs. Many other indices are only a few percentage points away from their respective peaks.

The higher the government support, technology presence and control over the Covid situation, the better has been the market performance.

This strong move in the market has had a lot of support from monetary and fiscal policy. This is not the first time that this has happened. Post Global Financial Crisis (GFC), high liquidity infusion had caused markets to trade at a higher valuations. In the US, the market cap-to-GDP ratio has seen a very high inverse correlation to interest rates and a very high correlation to increase in Fed balance sheet.

This time around, many more central banks are increasing their balance sheets compared with GFC period. A sharp increase in balance sheets has been witnessed over the past six months for most central banks.

RBI, the Indian central bank, has also seen a sharp increase in its own balance sheet. Higher liquidity infusion does bring interest rates down. With a reduction in yields, investors have to take a higher risk to generate the same returns as the flow of money into riskier asset classes increases over time. Thus, the risk premium in the market reduces and riskier assets trade higher.

Given the strong increase in size of balance sheets of most central banks during the Covid-19 crisis, I expect the low interest rate scenario to persist and higher valuations to hence sustain. My base case is that markets could trade at significantly higher-than-average valuations till liquidity conditions become benign. This would be reflected in improved market cap-to-GDP ratios/ higher PE ratios or a higher price to book value ratios vs long period averages. Once the liquidity increase stops and central bank balance sheets start to shrink and interest rates start to increase, overtime we should expect the market return to be lesser than the growth in EPS, thereby correcting the valuations back to average levels.

Hence, while our market cap-to-GDP is now back at average levels and PE is higher than average. We do expect these valuations to sustain. The higher risk premium that was there at the beginning of the Covid-19 crisis has corrected itself on strong liquidity infusion.

As index EPS of FY22 is expected to be significantly higher than FY20 EPS, we do expect the market to discount the same over the next one year and expect to see the indices scale its earlier highs over this period, delivering early teens returns from current levels.

There has been some focus on new investors coming into the market. The percentage of non-institutional volumes has shot up substantially than earlier. Retail investors took the benefit of lower valuations, showed confidence in the India story and came in strongly. This is a positive.

Promoters also took the opportunity to increase their holdings. Usually, higher retail participation is seen as a risk indicator. However, this time around since it has happened at lower valuations, even the more informed promoter groups have increased their holdings; it should be seen as a positive.

Which part of the market would do relatively better?

In the past, a higher liquidity-lower interest rate scenario helped higher quality asset-light consumption businesses more compared with levered capex-oriented businesses in terms of stock market performance. This is counter-intuitive, but was seen very starkly during the 2009-2020 period.

Free cash flow businesses, businesses with cash on books did very well while levered businesses/commodity producing businesses where the underlying commodity prices were volatile, did not do as well. This was in part on account of excess capacity that was built in the prior period.

Excess capacity in most industries persist even today. This may also have been on account of a change in capex preferences; for example away from coal-based thermal power to solar power. The polarisation of the market post GFC has been a global phenomenon. In India, it also had an overlay of corporate governance issues.

We do expect the same trends to continue in this period of higher liquidity. Stronger NBFCs should benefit strongly from a good liquidity and lower interest rate scenario, as they would see margin increases. The advantage that a bank has of a deposit taking franchisee vs an NBFC would be less of a competitive advantage in a scenario of surplus liquidity. We do expect high quality businesses in pharma, IT and telecom sectors to benefit from this trend apart from consumer sectors.

The focus would remain on consumption, and categories where growth of a secular nature can be expected over the next few years. Falling discount rates and secular growth can sustain very high valuations.

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