The 2019-20 budget is done and dusted. As with most Indian budgets, this one too was a big yawner except in its implications for the stock market.
Any prediction about the direction of the Indian stock market must be laced with caution. It is a market driven by a small universe of stocks. Although there are 5,000 companies listed on the BSE and about 1,600 on the NSE, the vast majority of them (about 80%) have little liquidity and minimal float. Also, short selling of stocks in the cash market is limited to intra-day trading—all short positions must be settled by day end. And while longer-term short selling using Futures and Options is available, in practice only about 100 companies have liquid contracts. Short sellers are a vital part of every market because they bet on the market going down, which puts a lid on market exuberance. A restricted short-selling environment provides an upward bias to the Indian stock market.
Having said that there are four reasons why I think this year will be a challenging year for the Indian equity market.
1) Valuation: The Indian stock market is expensive both on an absolute and relative basis. The price-earnings multiple (PE) of the Nifty index is around 27, which is 45% higher than its historical average of 18.5, and almost 58% higher than the PE multiple of the MSCI Emerging Market Index. Even if earnings grow at the same rate as nominal GDP of around 11 per cent (which appears highly unlikely), the one-year forward price-to-earnings (PE) ratio of Sensex would be at 25, while the MSCI EM and MSCI World are available at PE’s of 11.4 and 14.9, respectively (data from Bloomberg). The high PE multiple is indicative of an Indian stoc market that is overvalued and expensive. We know from empirical evidence that price-earnings multiples are mean-reverting, so expect a reduction in the PE multiple through a downward drift in the price of stocks.
2) Earnings: In the long run, earnings drive stock prices. A high PE is justifiable only if corporate earnings are expected to rise. However, profits of Indian corporates are at a 15-year low and expectations are for things to get worse this year. Earnings of Nifty-500 companies, as a per cent of GDP, declined from 5.5% in 2008 to 2.8% in 2018. And the pain is not confined to the universe of listed companies. The corporate profit-to-GDP ratio for all companies, including privately held firms, dropped from 7.8% in 2008 to 3% last year. From 2003 to 2008, Nifty-500 profits grew at a CAGR of 31 per cent, more than twice the pace of the underlying nominal GDP growth (CAGR of 14.5 per cent). But from 2013 to 2018, nominal GDP grew at 11% (according to the government figures) while corporate profit grew at only 3.8%.
Recent economic data shows a massive drop in vehicle sales, a significant reduction in the consumption of food items and slowing growth in core industry segments. Car sales have dropped for ten consecutive months to reach their lowest level in 8 years. Demand for oil, which is a good proxy for economic activity, was the weakest in five years. Things are slowing down, and the economy is tied up in a vicious circle of slowing consumption, lower investment, and weaker earnings. It is doubtful that this year will bring good news on the earnings front.
3) Buyback Tax: Companies often buy back their own shares to boost their earnings per share. In a buyback, the company repurchases a certain amount of its outstanding shares. Once taken back, these shares are extinguished by the company, which reduces the number of shares outstanding. Since the denominator gets smaller, it improves the earnings per share for continuing shareholders and enhances return on equity. In the recent budget, a new 20% tax was imposed on all buybacks, as a result of which there will be a significant reduction in share repurchases by companies. Any hope of a bump in earnings from a reduction in shares outstanding is lost, and stock prices will decline as a result. Just yesterday, KPR Mill withdrew its buyback plan and its shares dropped by 6%.
4) Excess supply: There will be a large supply of new shares coming into the market from two announcements in the budget. Firstly, the minimum holdings for outside shareholders in listed firms will be increased from 25 per cent to 35 per cent. As a result, promoters in about 1,174 listed companies will have to reduce their holdings by providing their shares to the public. At current market prices, the total quantum of new stock that will come into the market as a result of this announcement is a whopping Rs 3,87,000 crore. This new supply of shares will put significant downward pressure on stock prices. The second announcement in the budget was the disinvestment of public sector companies—a welcome move, but one which will add another Rs 1.1 lakh crores of new shares to the market.
The combined effect of these two announcements will inject Rs 5 lakh crores of new shares into the market. We know from economics that when the supply of any product increases, its price falls. Stocks are no different, and prices will, therefore, fall as a result of this additional supply.
The prognosis for the Indian stock market is not good. Based on fundamentals (earnings and liquidity), and momentum (other emerging markets are outperforming India in 2019) it is going to be extremely hard for the Indian stock market to stay in the green in 2019.
Here is my prediction for the Indian stock market by year-end 2019:
Best-case scenario (probability 10%): Nifty at 11,500 and Sensex at 38,000
Most-likely scenario (probability 60%): Nifty at 10,400 and Sensex at 34,000
Worst-case scenario (probability 30%): Nifty at 9500 and Sensex at 30,000