THE BIG STORY. End of bull run?

The ongoing bout of volatility in the stock market has given rise to two questions. Is this the end of the bull market? How deep can this correction get? Attempting to predict the market’s moves is a mug’s game but we can look at the market’s behaviour in the past, especially at previous peaks, to answer these questions.

In the recent past, the Indian stock market has formed significant peaks twice, in January 2008 and in March 2000. We have only considered peaks that were followed by decline of more than 50 per cent for this analysis. The 2008 peak was followed by a fall of 63 per cent in benchmark indices whereas in 2000 there was a 58 per cent fall.

We compared valuations, investor behaviour, corporate earnings, economic growth and market internals that prevail now with corresponding numbers around the January 2008 and March 2000 peaks to understand how different the conditions are now. The good news is that despite the sharp run-up in stock prices over the last two years, market parameters now do not indicate a significant bull market peak at this juncture.

Yes, valuations are stretched, but not to the extent they were in the previous peaks. Turnover data and activity in the primary market also signal that sentiment has not hit the euphoric levels typically seen towards the end of frenzied bull runs. The dismal corporate earnings in recent quarters is another departure. We can, therefore, assume that this is not the end of the bull market but a corrective dip in a multi-year uptrend. There could be further decline on the cards, but the structural uptrend will eventually resume to take the market to new highs.

The Nifty was trading at a price to earnings (PE) multiple (trailing 12 months) of 22 towards the end of April this year. This is higher than the five-year average PE multiple of around 19 but much below the peak valuations hit before the 2008 and 2000 peaks.

Before the market sold off in 2008, the Nifty was trading at a much higher multiple of 27.6 times. In February 2000, before the dotcom bubble burst, the Nifty was trading at a multiple of 28.4 times.

The estimated forward PE multiple for the Nifty for FY16, at around 15.5 times, too lends comfort.

If we measure Nifty’s valuation on the price to book ratio, it was available at 3.5 times book value towards the end of this April. The ratio has not changed much since the end of December 2012 when the Nifty was trading at 3.13 times its book value; despite the 38 per cent rally in the index since then. It implies that the growth in India Inc’s net assets has kept pace with the increase in stock price over the last two years.

On a price-to-book metric too, the Nifty has not reached peak valuation yet. In December 2007, this ratio was 6.4 and in February 2000, it was 5.1.

Market capitalisation to GDP ratio is another metric that can be used to judge if the market has turned expensive. A ratio of around 1 implies that the market is rightly valued whereas a value below 1 signals room for growth. Currently, the market cap to GDP ratio is 0.87, which signals absence of a bubble.

According to the World Bank, India’s market cap to GDP was 1.47 in 2007, when the bull market was at its fiercest. That was a clear sign of an overheated market, waiting to fall. In 1999, this ratio was just 0.39, probably due to fewer stocks in the listed universe at that point. This number is, therefore, not comparable.

Froth in the market can also be gauged by the extent of retail participation in the market. Since retail investors typically transact in the cash segment of the stock market, the volume in this segment can provide some clues. Average daily turnover in the cash segment of the National Stock Exchange moved up from ₹11,191 crore in FY14 to ₹17,756 crore in FY15. This is a 58 per cent jump. Since this number is a proxy for retail interest, we can assume that retail investors could be returning to stocks.

But the increase is lower than that recorded during previous tops. Average daily cash turnover in FY2008 was 80 per cent higher than in the previous fiscal. In FY2000, daily cash volumes doubled over the previous year.

Cash market data, therefore, does indicate increased interest among long-term and retail investors but it has not reached worrying proportions yet.

Derivative data typically reflects trading interest in the market. Derivative volumes have been hitting record highs, of late. Average daily derivative turnover is up 50 per cent in FY15 over the previous fiscal year. But this increase is lower than the 76 per cent increase recorded in FY2008. Currently, derivative trading is concentrated in index options that account for over 70 per cent of the turnover now. These are relatively less risky as the loss in these instruments is limited to the premium paid. But in 2007-08, stock futures accounted for 57 per cent of the turnover. The loss can be unlimited in stock futures and many retail investors burnt their fingers in these instruments in 2008.

Heightened activity in the primary market is another indication of a potential market peak. This is because promoters usually go into an over-drive by increasing stock prices and trying to offer stocks at high valuations.

It is probably for this reason that many stocks, including the mega Reliance Power offer that listed just before the market crash of 2008, are now trading well below their listing prices. In 2007, the Indian IPO market was extremely active with 94 offers made in this period. These included high-profile failures such as DLF, HDIL and Simplex Projects.

In contrast, only five new companies listed on the NSE in 2014. The somnolent primary market is partly due to regulatory action against promoters and investment bankers for manipulating stock prices on listing day. But this dullness also implies that new investors are staying away.

The state of corporate earnings is also quite different from the conditions that existed in the two prior peaks. Aggregate revenue of Nifty companies in the December 2014 quarter declined 2 per cent while earnings grew 14 per cent; largely due to extraordinary items. Earnings fell compared to a year ago if extraordinary items were excluded.

Prior to the 2008 peak, however, India Inc was going great guns with revenue and net profit of Nifty companies increasing 21 and 15 per cent respectively, over the same quarter of the previous year. It was the same story in 2000. The growth in revenue and profit in December 1999 was 26 and 36 per cent, respectively.

These numbers indicate that the market seldom peaks when corporate revenue earnings are struggling. The peak in earnings and stock prices appears to move in tandem, most of the time. Since the rate of growth is slow, a further disappointment may not impact valuations too much.

The economic growth also seems to hit a peak along with a significant market peak. GDP growth rose from 4.3 per cent in 1998 to hit a high of 7.6 per cent in 2000. It was down to 4.3 per cent again in 2001.

Similarly, economic growth peaked in 2008 only to decline sharply by mid-2009. There has been a surge in growth in December 2014 at 8.2 per cent, followed by a small dip to 7.5 per cent in the March 2015 quarter (based on the new GDP numbers). With most international agencies, including S&P and IMF, pegging India’s growth between 7.5 and 8 per cent this fiscal, the market fails the economic growth test as well.

With valuation, economy and company fundamentals not meeting the conditions prevalent at significant market peaks, we can safely conclude that a deep correction of 50 to 60 per cent is ruled out. So, how far can this correction go? Smaller declines that occur between multi-year uptrends can make indices fall up to 30 per cent from their peaks. That would give us the outer limit of 6,383 in the Nifty and 21,000 in the Sensex. Do note that these were also the peaks formed by the two indices in 2008 and in 2010.

If there is a serious global risk-off and all markets go into a tailspin, we will have to start looking at that possibility.

That is, however, the worst-case scenario. We can have a bottom much above, around 24,500 on the Sensex and 7,500 on the Nifty. These are based on Fibonacci retracements of the previous upmoves. Such declines should be construed as buying opportunities.

COMMENT NOW