10 warning signs for investors in the current stock market rally

10 warning signs for investors in the current stock market rally

10 warning signs for investors in the current stock market rally

It would be an understatement to say that the Indian equity market is on fire right now. The benchmark Nifty 50 index is up 57 percent from its March lows, making it one of the fastest ever recoveries in the markets since the 2008 global financial crisis. In 2009, the Nifty 50 index took 9 months to double from its March 2009 lows.

This has been a financial bonanza for equity investors and traders who stayed invested in the market at the peak of the gloom in February and March this year.

Market fundamentals however suggest that it’s time for investors and traders to book profits and go light on equity till the market cools down a bit. 

Here are 10 points that investors should keep in mind in the current environment.

1.       On the face of it, the current rally in the broader market is less intense than the 2009 rally post the Lehman Crisis, but there is a fundamental difference between the two. The 2009 rally went hand-in-hand with the post-Lehman recovery in the Indian economy and corporate earnings. The Nifty 50 index underlying earnings per share (EPS) was up nearly 10 percent during March-December 2009 which provided some fundamental justification for the market rally during the period.

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2.       In contrast, the current rally is all hope with no positive momentum in either the economy or corporate earnings. Indian economy is expected to contract by 10-15 percent in FY21 according to various estimates and corporate earnings are down by a quarter in the last 6 months. For example, the Nifty 50 index underlying EPS on trailing 12-months basis is down 24 per cent from its record high in January this year post corporate results for December 19 quarter. At Rs 343 per unit of Nifty, the index EPS is lowest in nearly seven years. 

Going forward, the pace of earnings contraction may slow down but corporate earnings may continue to decline for at least two more quarters.

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3.       As a result, most of the gains for equity investors have come from expansion in stock valuations rather than rise in earnings and higher equity dividend from their investments. At Wednesday’s close, the Nifty 50 index was trading at price to earnings multiple of 35x, the highest ever. In comparison, index P/E has been around 20x on average in the last 10 years. The current valuation is nearly 25 per cent higher than what the market witnessed at the peak of the 2000 dotcom boom and pre-Lehman boom in 2007. History suggests that retail and individual investors mostly lose money when investing at valuations closer to previous highs.    

4.       Most of the gains in the broader market and the index since March this year have come from 5 stocks – Reliance Industries, HDFC Bank, Infosys, Tata Consultancy Services and HCL Technologies. But none of the companies are showing the earnings momentum that matches their current optimistic valuation.

5.       Reliance Industries stock price has more than doubled in the last 6 months even though the company’s net profit was down in the March and June 20 quarters due to a sharp fall in oil prices. HDFC Bank continues to report earnings growth but the true health of the banking industry has been hidden due to the ongoing uncertainty about loan moratorium and restructuring of stressed accounts.

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6.       This leaves the IT sector which was least impacted by the COVID-19 lockdown but the industry growth momentum has been falling for a while despite all the positive vibes on display in popular media. For example, Tata Consultancy Services net profit has contracted in the last three quarters. Infosys has done relatively better but 12 percent growth in earnings on a year-on-year basis cannot justify a P/E of 30x.

7.       The sustainable rate of earnings growth for IT companies is much lower. Their revenues are growing at around 6 percent on an annualised basis, translating into 5-6 percent growth in earnings on a sustainable basis. The immediate cause for rally in technology stocks is large stocks buy-back announced by TCS and Wipro. But the American history of stock buyback suggests that they reduce a company’s growth potential over the longer-term and hit shareholders.

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8.       American technology giant IBM is the biggest poster child of a company’s decline through buybacks. This is not very surprising. In buyback, companies buy their shares at a premium to the market price and if they have to raise capital, they sell shares at a discount to the market price. This is corporate finance upside down and is a waste of capital that should have been used to invest in new technologies and ideas to drive future growth.

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9.       The combined market capitalisation of IT companies is now up 45 percent since the beginning of September this year. They have single-handedly pulled up the market from its September lows. At Wednesday’s close, the top five IT companies were trading at a record high price-to-earnings multiple of 29x. In fact, the IT stocks are now more expensive than in the 2008-2014 period when their earnings were growing at 15-20 percent annually.

10.   A record high valuation and earnings contraction is a deadly combination and can catch many investors on the wrong foot. The market can see a sharp correction at the first whiff of a global reversal in sentiments of a macroeconomic shock to the Indian economy. Use the current rally to book profits and generate cash flows to insure yourself against the market reversal.

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

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