Equity: Bubble or Bull Market

The Indian equity market has seen a remarkable surge in performance, particularly within the broader equity indices. Over the past six months, these indices have surged by over 30 per cent, significantly outpacing Nifty 50, which registered an increase of only 11.7 per cent during the same period. Investors are therefore rightly concerned about whether this is just a mere bubble that may soon be pricked. The report takes into consideration historical data to arrive at the truth 

In a remarkable display of strength and resilience, the Indian equity market has delivered an outstanding performance over the past six months ending August 2023. With Nifty 50 surging past the coveted 20,000 mark and both the Mid-Cap and Small-Cap indices scaling unprecedented heights after a one day hiccup, the Indian stock market has been on a remarkable bull run. What’s even more astonishing is that this surge has not been confined to domestic boundaries alone. The Indian equities have boldly outshone their international counterparts, emerging as a shining star in the world of investments. The MSCI India index is up by 15 per cent in the last six months compared to the MSCI World index which has been up by 11 per cent while the MSCI Emerging Markets index is up by only 2.5 per cent in the same period. 

The Indian equity market has seen a remarkable surge in performance, particularly within the broader equity indices. Over the past six months, these indices have surged by over 30 per cent, significantly outpacing Nifty 50, which registered an increase of only 11.7 per cent during the same period. To put these returns in perspective, consider that over the past 18.5 years, Nifty has, on an average, delivered an annualised return of 12.9 per cent. In contrast, the mid-cap and small-cap indices have delivered even more impressive returns, averaging 15.7 per cent and 14.4 per cent, respectively, over the same period. 

The Large-Caps represented by Nifty have generated returns of one year in six months while the mid-caps and small-caps have generated double the yearly returns in half the period. This substantial outperformance by the broader equity indices raises a fundamental question about whether the market is in a bubble. Such huge returns in such a small span of time questions the continuance of the momentum. So, to have a comprehensive understanding of this we will dig into historical data to know if this is likely to continue.
 

Historical Six Months Returns


To understand the return behaviour of equities in six months, we studied the historical returns of Nifty indices for the past 18.5 years. The table shows the statistics for the rolling returns of indices for six months starting April 2005. All the three indices on an average have generated positive six-month rolling returns in our period of study. Nifty 50 has the lowest mean return, but it also has the lowest standard deviation, indicating that it is the least volatile of the three indices. The mid-cap and small-cap indices have higher mean returns and higher standard deviations, indicating that they are riskier but also have the potential for higher returns. 

It’s worth highlighting that the current returns of large-cap stocks, as represented by Nifty 50, have surpassed the average returns they have generated in rolling six-month periods since 2005. This means that in recent times the large-cap stocks have been performing exceptionally well compared to their historical performance over similar timeframes. The situation is similar for mid-cap and small-cap stocks, where their current returns have exceeded even the 75th percentile of their historical averages. In simpler terms, these stocks have been delivering returns that are higher than what they typically achieve threequarters of the time. 

However, it’s essential to note that despite these impressive performances, all these indices are currently trading below their average returns plus one standard deviation. The standard deviation is a statistical measure that quantifies the amount of variation in a set of values. In this context, it’s used to gauge how far the current returns are from the historical average, considering the level of volatility or fluctuations. So, while the recent returns are strong, they are still within a reasonable range when considering historical volatility. 

The following table gives a glimpse of the performance statistics of the three Nifty indices in the last 18.5 years.

The above return analysis shows that though the current returns are above the mean and 75 percentiles, it is not alarming. Now, let us analyse other factors to understand if we are in the bubble zone. 

General Market Sentiment

While numerous market indicators exist, we will focus on a select few to gauge the current market sentiment, specifically using BSE 500 stock prices for our analysis. First, let’s examine the 52-week high-low indicator that indicates market strength. This index identifies stocks reaching their highest point within a year as market leaders in strength, while those hitting their lowest point in the same period are considered leaders in weakness. The 52-week high–new low indicator (52WNH – 52WNL) measures the behaviour of these leaders by subtracting the number of new lows from the new highs. This serves as a reliable leading indicator for the stock market.

This indicator is presented as a 20-day moving average, representing the difference between companies reaching a 52-week high and those hitting a 52-week low. It essentially reflects the balance of power between market leaders in strength and those in weakness. Currently, this indicator stands significantly above zero, indicating market strength and suggesting a favourable market outlook.

Short-Term Trading Index

Another crucial market sentiment gauge is the short-term trading index (TRIN) or Arms index. TRIN represents the relationship between advancing and declining issues by measuring their volume flow. A rising TRIN depicts a weak market and a falling TRIN depicts a strong market. We will use a moving average to smooth the data. The TRIN will read under 1.0 when advancing stocks are the major source of volume and above 1.0 when declining stocks are the predominant source of volume flow in the market. The graph shows that it is marginally above 1 but approaching towards one and hence this indicator also does not give any alarming signs.

Stocks Trading Above 50-Day MA

Many a times, the momentum of the market is also gauged by how many stocks are trading above certain moving averages. Each price represents a momentary consensus of value among market participants, while a moving average represents an average consensus of value during its time window. This means that when a stock trades above its MA, the current consensus of value is above average—bullish. When a stock trades below its MA, the current consensus of value is below average—bearish. When the market is trending higher, the percentage of stocks above their moving averages keeps growing. In a broad downtrend, the number of stocks above their MAs keeps shrinking. 

The chart clearly shows that almost 90 per cent of the companies are trading at a price above the 50-day moving average, which shows great strength in the market. The above market indicators clearly show that the sentiment in the market is still strong and we not showing any signs of worry or bubble.
 

Valuation

The above indicators are the effect and the cause of the financials and valuations of the equity market. Currently, Nifty 50 boasts a trailing price-to-earnings (PE) ratio of 22.28 times, which surpasses its historical median of 21.62 times. This suggests that large-cap stocks are trading at a slightly higher valuation than what is considered typical over the long term. A similar trend is observed in the broader market, with both small-cap and mid-cap indices trading above their respective long-term averages. Nifty Small-Cap index, for instance, currently holds a PE ratio of 24.79 times compared to its longterm median of 24.61 times. 

While this indicates a relatively elevated valuation, it’s not excessively so and remains close to its historical norm. Similarly, Nifty-Mid Cap 250 index exhibits a trailing PE of 26.19 times, above its long-term median PE of 21.88 times. However, it’s important to note that mid-cap stocks, on an average, appear to be trading at a moderately higher PE than their long-term average, without reaching alarming levels. 

Shifting our focus to another vital valuation metric, the priceto- book value (PBV) ratio, we find that the indices are currently trading at a premium compared to their long-term average. Large-cap, mid-cap and small-cap indices are trading at premiums of 19 per cent, 37 per cent, and 70 per cent, respectively, above their long-term averages. This indicates that the current valuations when measured through PBV are indeed elevated compared to historical norms with the small-cap index standing out as trading at a significantly higher valuation than its long-term average. This suggests that the Indian equity market is currently overvalued, but does this mean a red flag for the equity market? 

To understand it better we studied historical peaks from where the market started to reverse or showed negative return for some time and what valuations they were trading at. We identified four such instances in the last 15 years – January 2008, March 2015, January 2018 and October 2021. The following two bar graphs show how the PE and PBV compared to the historical peaks. 

Analysing the latest available data as of September 7, 2023, it’s evident that Nifty 50, Nifty Mid-Cap 150 and Nifty Small-Cap 250 indices are currently trading at trailing price-to-earnings (PE) ratios of 22.28, 26.19, and 24.79, respectively. 

Comparing these figures with historical data from earlier data at a time when the indices reached their temporary peak, it’s apparent that the market’s valuation is not alarming. Nifty 50’s PE ratio on September 7, 2023 is relatively lower than its levels in January 2008 (28.29) and January 2018 (27.5). Similarly, the small-cap index’s current PE of 24.79 is more reasonable than its peak in January 2018 (76.43). 

However, it’s worth mentioning that the mid-cap index, despite being lower than its level in January 2018 (51.2), has seen an increase in valuation since 2021 (35.46). Hence, we do not see the indices currently trading in the bubble zone.

Now let us analyse the above factors with forward looking. We analysed the forward PE and PBV of Nifty and the mid-cap and small-cap indices. Evaluating the valuation on PE basis, all the indices are found trading at reasonable valuations. They are trading near to near one standard deviation above the mean. Nonetheless, on PBV basis, small-cap and mid-cap indices look a bit expensive and are found trading at above one standard deviation of the mean.

Macroeconomic Factors

These valuation ratios alone do not present a comprehensive view of market valuation. Several other critical factors influence market conditions, including GDP growth, interest rates and inflation. The outlook for real GDP growth is optimistic, with expectations of 6.3 per cent growth for both FY24 and FY25, which surpasses the IMF’s global growth projections of 3 per cent for the same period. A key driver of FY24 growth is anticipated to be capital expenditure. While inflation experienced a temporary spike due to rising vegetable prices in July and August, recent data shows a decline to below 7 per cent, beating the economists’ expectations. It is anticipated that the consumer price index (CPI) inflation will average 5.7 per cent in FY24, within the Reserve Bank of India’s comfort zone. 

Furthermore, government-led supply-side reforms for essential commodities like vegetables, cereals, pulses and sugar are expected to mitigate incremental inflationary pressures. Considering the inflation scenario, interest rates are likely to remain stable in the near term and could decrease in the following year. The RBI may initiate interest rate cuts at some point during FY25. Globally, central banks such as the US Federal Reserve and the European Central Bank are nearing the peak of their interest rate hike cycles. These broader economic factors, in conjunction with market valuations, show that we are not in the bubble zone as of now. 

Earnings Trajectory

Despite the prevailing higher interest rate environment, the trajectory of growth and earnings continues to display resilience. High-frequency data paints an optimistic picture, with various indicators showcasing positive momentum. Notably, the automotive sector, a reliable high-frequency gauge, demonstrated an upswing in August. The Federation of Automobile Dealers 

Association reported a robust 9 per cent year-on-year growth in automotive retail sales during the same month, spanning across multiple vehicle categories. Furthermore, electronic permits for goods transportation, both within and across states, surged to a record-breaking 93.4 million in August. 

This upswing hints at brisk economic activity, which has the potential to bolster Goods and Service Tax (GST) revenue collections in September. These high-frequency indicators align with the August manufacturing Purchasing Managers’ Index (PMI) data, which indicates robust demand and output growth. Additional data from Indian Railways reported a notable increase in goods shipment and economic activity, with 126.95 million tonnes loaded in August, marking a 6.38 percent growth compared to the previous year. As the festive season approaches, expectations are high for a further boost in demand and corporate earnings. 

Nifty 50 consensus earnings per share (EPS) for FY24 and FY25 stand at ₹ 990 and ₹ 1,128, respectively. This reflects growth rates of approximately 20 per cent and 14 per cent and translates into price-to-earnings (PE) ratios of 19.7 times and 17.3 times for the respective years. The mid-cap companies are poised for an even stronger performance with FY25 profit growth projected at 20 per cent compared to Nifty’s 15 per cent. This premium of around 25 per cent can be attributed to the robust GDP growth, which has translated into higher growth prospects for mid-cap and small-cap companies.
 

The Stumbling Blocks

Elevated commodity prices driven by El Nino have the potential to trigger inflation, disrupting some of the favourable economic dynamics and potentially hindering growth momentum. Approximately 28 per cent of the combined weight of large-cap and mid-cap companies lies in sectors vulnerable to both revenue and margin pressures due to these factors. Furthermore, sectors like chemicals and IT are yet to exhibit signs of recovery, together contributing around 15 per cent to the weight of NSE’s top 200 companies. Post the festive season, the focus will shift to elections, and any unfavourable outcomes in these elections may impact broader macroeconomic and equity trends. 

Also, resurgence in China’s economic activity could divert some immediate investment inflows away from India and towards China. However, barring unforeseen events and the aforementioned concerns, our outlook for Indian equities remains positive, and we do not currently detect signs of widespread market overheating. While some sectors and companies may exhibit excesses, we do not perceive this as a systemic issue that would lead to a sharp market correction. Given that most of the easily attainable opportunities have already been realised and valuations are not unduly cheap, it is advisable to adopt a comprehensive top-down and bottom-up approach in stock selection, ensuring diversified exposure across sectors and market capitalisations.