On the face of it, the current rally in the market looks well spread out. So far in the year, the sensex has gained over 19%, the mid-cap index is up 24%, while the small-cap index has jumped 31%. Every two out of three sensex constituents are up in 2017, while the top six have contributed 71% of the gains.
However, the short-term data show even as the valuations have jumped substantially, the rally has narrowed with strong buying in just a handful of stocks, which is taking the index to new highs on a regular basis. Even on Tuesday, the 30-share index touched a lifetime high of 31,885, but closed at 31,747 - up just 31 points.
Consider this: At 23.3, sensex's one-year trailing price-to-earnings (PE) ratio is at a level not seen since January 2011. A high P/E indicates investors are willing to pay a higher price for each rupee earned. And for the mid-cap index it's at nearly 32, while for the small-cap index it's at 74 - the highest in the last three years. BSE data before April 2015 is not available. For a large-cap index like the sensex, any count above 25 is considered to be dangerous which, if not corrected, could take the market into a bubble zone.
Also, the rally seems to be riding on just a handful of stocks. So far in the fiscal, the sensex has risen nearly 1,800 points. Of this, more than 50%, or 1,164 points, have come due to strong buying in just three stocks - ITC, HDFC Bank and Reliance. In other words, just 10% of the sensex's 30 stocks were responsible for more than half of the index's rise in FY18. In comparison, the same three stocks have contributed less than half (46%) of the sensex's 5,121-point rally since the start of 2017.
All these data points are prompting a large number of market players looking for a correction at current levels, which they believe would be healthy for the rally to sustain in the medium term.
According to Raamdeo Agrawal, co-founder, Motilal Oswal Financial Services, stock markets run on hope and expectations. So naturally the PEs of an index and stocks also reflect the hopes and expectations of the investors relating to that index and those companies. "In a way, we can also say that the PE ratio is actually the 'price-to-hope' ratio. When hopes and expectations are high, the PE rises, while in times of muted hopes and expectations, the PE corrects," he said.
Agrawal believes the current rally is on the back of strong expectations that Narendra Modi will be re-elected and hence the euphoria among a large number of investors on the Street. "I'm expecting some correction at current levels, but I'm not sure if the same would be a price correction or a time correction," Agrawal said. In case of a price correction, the stock price falls which brings down the PE ratio. And during a time correction (also called consolidation), which happens over several months, the index or a stock doesn't show much movement but the earnings rise to eventually bring the PE ratio down.
Fund managers too have been raising warning signs relating to valuations. In a recent communication to investors, Rajiv Thakkar, CIO, PPFAS MF, told investors that it was opting for underperformance over "throwing caution to the winds" as the fund more than doubled its holding of cash and equivalents in six months to about 17% by June end. And one of the reasons is it sold stocks in which valuations were stretched. "There are some investment managers who see the present at a new era for India and that the size of the opportunities justify any valuation. We are clearly not in that camp. While we recognise the potential, we will continue to be anchored by valuation parameters and will wait for the right opportunity to come by," Thakkar had written to his investors a couple of months ago.
In February, DSP Blackrock stopped accepting fresh inflows in its Micro Cap Fund, arguing that additional money in the scheme would be detrimental to the interests of the fund's existing investors. The fund is yet to lift the restriction.
The original article could be seen here.