These days I see a lot of investors and perhaps fund managers running out of ideas. The general view seems to be that stocks are either too expensive or not worth owning because of poor fundamentals. My view differs to the extent that large caps that are not overburdened with debt will either continue to outperform or remain range bound. As for the current high valuation for stocks, you will find my view below.

Here are 3 Reasons Why Markets are Rallying:

  1. Favourable Macros: low Interest rates, bond yields, inflation and oil prices: Low inflation and good monsoon suggests that RBI is likely keep the rates unchanged or even cut interest rates further. FED’s commentary indicates that the main central bank is not going to increase interest rates anytime soon. This has created enormous liquidity for foreign investors who are buying stocks in an environment of multi year low bond yields. Keep in mind that FII money can move in and out of the market fairly quickly so in case there is a correction, it will be equally sharp.
  2. Corporate earnings are improving:

For FY Q1 of 2017, earnings improved 24% (y-o-y) and 16% (q-o-q). This is the strongest corporate earnings improvement the markets have witnessed over the last 4 years. The hope is that the trend will continue.

My views on current high valuation: The PE Multiple on the Nifty is at 24.5 which is ~ 22% higher than its 10 year average. While one may argue that this is as high as it gets and that stock prices must correct, the truth is that it will not be the first time when valuations will cool down without a big correction in stock prices, if that were to happen. If you look at the quarterly results for the last 4 quarters, leaving aside Q1 of 2017, the reaming 3 quarters (based on which the PE multiple is calculated) posted extremely poor results.

If earning for the remainder of FY 2017 improve as much as they improved in Q1 (I.E. 24% y-o-y), then at the current level of market, the PE would be ~ 19.2, in which case the markets are absolutely perfectly valued.

What does this mean?

This means that if earnings were to improve further, the markets will be able to sustain the momentum or at worst, trade at the current level.

If earnings do not improve, we will see a correction – may be a strong correction.

How much should the earnings improvement be for the rest of this Financial Year for current prices to be justifies – perhaps 20%+. Of course this is very ambitious but given how poor the base of earnings for FY 2016 has been, it is very achievable. This rally is largely based on the hope that earnings will improve a lot!

  1. For good or bad, the sentiment is extremely bullish – Markets, at least in the short term are driven by sentiment. Sentiment in turn gets driven by a variety of reasons – long period of rising stock prices can, and in this case have turned scepticism into optimism. Market commentators and positive media reports have helped the cause immensely. At some point when the sentiment turns bearish, there will be negativity and a correction. Markets may fall 5-7% or more. This happens twice a year or so.

That said, the markets are unlikely to correct a lot as I have stated in my view above. In addition to improvement in fundamentals and corporate earnings, the other thing that’s positive for the market is the fact that if you leave aside FIIs, most domestic institutions and retail are sitting on record levels of cash. Any correction will be bought into pretty massively I believe.