Last week, the Indian market hit an all-time high. The Nifty just crossed 19,200 and fell back, while the Sensex crossed 64,700. There is strong bullishness all around, with some suggesting that the momentum is so strong that the index will quickly cross 20,000 and go higher. Suitable 'narratives' are always available to support such market forecasts when stocks break out or break down.
This time, ‘experts’ point to favourable winds for stocks such as lower inflation, pause in interest rate hikes, and normalisation of the global economy, which grew massively in 2021 but suffered a severe economic shock from Russia’s invasion of Ukraine in February 2022.
Analysts and fund managers usually rely on something other than narratives to forecast the trend of the Nifty, now the bellwether of market mood—and that is earnings.
According to conventional wisdom, growth in earnings drives stocks higher. But it is not so simple. Although earnings growth is expected to drive stocks higher, in reality, stock prices are determined by countless other factors, primarily impactful economic, social and political events.
Earnings growth is the only factor that is somewhat measurable and so we attach a lot of importance to it—perhaps more than what is justified. Anyone with some knowledge of market behaviour knows earnings and prices can diverge quite a bit. Earnings can be stagnant while stock prices rise and vice versa. Even if you know the extent to which earnings will rise, it won’t help you forecast index movement; and yet, analysts have been at this futile exercise for decades.
On the other hand, if you know that there will not be any significant rise in earnings, and do not invest, you could miss out on serious market upmove.
Here is the evidence. In December 2022, the Nifty was over 18,800 and the earnings per share (EPS) of the Nifty 50 was Rs832. By March 2023, earnings had risen to Rs849 but the Nifty was down 2,000 points. If you think this is a short-term issue, consider the five-year period between January 2015 and January 2020, a phase of great expectations from the Modi government’s first term.
In January 2015, the Nifty EPS was Rs392 and by January 2020, the EPS rose a meagre 10% to Rs431. How did the Nifty respond to this anaemic growth over five years? It shot up 39%!
Like everything else in the markets, there is only a loose correlation between these two sets of variables. There are periods when the EPS and Nifty have risen in tandem and there are periods when they diverged, but divergence is a far more common occurrence. This is because very often, 'sentiment' drives prices well beyond what is warranted and it is hard to forecast market sentiment.
An extreme case of bad sentiment occurred between January and November 2008, when the Nifty crashed 43% from 6,239 to 2,672, even as the Nifty EPS rose from Rs222 to Rs228. So, markets tend to diverge from earnings growth in both, the short and long term. Is that why 'market experts' fall back on the economic narrative in support of higher (or lower) prices? But such narratives are even less connected to stock prices.
GDP Growth Vs Stock Prices
The centrepiece of the current narrative is strong economic growth. But GDP growth is also not strongly correlated with higher stock prices either, which is evident from the average performance of Chinese markets, even during its high-growth years. At the same time, although India’s GDP growth has been higher, the US market delivered better returns to international investors than the Indian market.
In fact, granular data underlying India’s economic growth does not look that strong. India’s private consumption is skewed—there is high consumption by a small number of the very rich at the top, while there is a slowdown in sales of mass consumption items since the vast majority of the lower income group has been hit hard by inflation and poor income growth.
India’s economic competitiveness hasn’t improved either, as reflected by the slow growth of our merchandise exports. A few pockets of manufacturing excellence (which grab the headlines and are used to illustrate bullish narratives), don’t change the basic picture. The fact is that private investment has yet to pick up.
On the positive side, the stupendous State-led push in infrastructure-building, railways and defence expenditures will yield results. A handful of companies is getting big orders in engineering and construction, while suppliers of humdrum products like pumps, wires, steel tubes, pipes, etc to these projects, are reporting strong growth and their stocks will become multibaggers. But it is hard to say how much this will benefit the economy as a whole.
After all, even Larsen & Toubro, India’s largest construction company, reported only a 3% compounded annual growth rate in profit growth in three years, 4% in five years and 9% in nine years. India’s largest cement company, Ultratech, reported a 4% decline in profit over three years.
Given these facts, while headlines about stock indices being at an all-time high may grab attention, it is senseless to predict where the Nifty is headed. That forecast would be determined by a narrative of our choice.
(This article first appeared in Business Standard newspaper)