The massive plunge in share prices in Indian markets on Tuesday morning had been tempered to some extent by the afternoon, when the indices recovered a bit from steep lows. But the morning carnage, which followed a similar rout in American shares and saw trillions of rupees in valuations disappear, may not be the last time in 2018 that Indians will be confronted with headlines about crashing stock prices. Analysts have been warning for some time now that Indian shares, which have boomed over the last few years, are overvalued and do not reflect the underlying weakness of the economy. According to this view, a correction in share prices is only to be expected.
Chief Economic Adviser Arvind Subramanian struck a clear note of caution over this issue in the Economic Survey tabled in Parliament just a week ago. Subramanian pointed out that India’s primary indices, the Bombay Stock Exchange’s Sensex and the National Stock Exchange’s Nifty, have both been booming despite dour news from the actual economy, high real interest rates and miserable corporate profits. This stood in stark contrast to the situation in the United States where stocks were also booming, albeit on the back of an economy that is growing strong, substantial corporate profit growth and negative real interest rates.
The Survey attempted to explain why US and Indian stock prices seemed to be following a similar path, despite such a huge difference in the conditions underlying both economies.
- Expectations of earnings growth are much higher in India. There were signs in early 2016-17 that a long slide in the corporate profits/Gross Domestic Product ratio might be coming to an end, and so investors began putting money into the market ahead of what they hoped would be a recovery. Instead, corporate profits continue to be tepid, meaning India was, by some estimates, the most expensive stock market in the world.
- Demonetisation. According to Subramanian, the note exchange program imposed by Prime Minister Narendra Modi meant that there was effectively a higher cost on other ways of investing or just saving: holding cash, trade in real estate or holding gold. As a result, investor and household money has been directed towards the markets instead, with mutual funds in particular seeing a massive growth.
Subramanian ended this section with a warning about the boom in Indian stocks. “Sustaining these valuations will require future growth in the economy and earnings in line with current expectations, and require the portfolio re-allocation to be semi-permanent,” the Survey said. “Otherwise, the possibility of a correction in them cannot be ruled out.”
The chief economic adviser is not the first to make such a warning, though it was significant coming in such a document. Analysts have been saying through much of the past year that Indian stocks are overvalued and that a correction, potentially of as much as 10%, might be likely whenever global and local conditions line up.
In the last few days, some of those circumstances have aligned. The announcement of a Long-Term Capital Gains tax on equities in the Budget led to some jitters in the markets. News that India would be breaching its fiscal deficit targets saw government bond yields going up, prompting more concerns about the health of the Indian economy. Global conditions were also a big factor, with the United States’ top share index, the Dow Jones Industrial Average, seeing a precipitous drop on Monday, bringing a number of other Asian markets down with it. The expected tightening of interest rates, starting in the US and moving elsewhere, has also caused jitters.
Ultimately, shares on India’s Sensex and Nifty indices recovered a bit on Tuesday, slumping by less than 1.5% over the previous day’s close in both cases. But as Subramanian and others have warned, the market remains overvalued and, unless there is a sustained recovery in the underlying economy and corporate profits, a correction in share prices is still very likely.