Whenever India’s stock indices scale new highs, a section of investors begins to worry about whether they are in bubble territory. Folks who’ve lived through earlier meltdowns such the dotcom decline or the global financial crisis crash are a particularly jumpy lot, expecting the indices to crash by 40 or 50 per cent after every new milestone.
However, as the Nifty50 flirts with the 23,000 mark and the BSE Sensex with 75,000 today, it is hard to make a case that the Indian stock market is in a bubble phase or that its valuations are frothy. Yes, there are pockets, where investors in the grip of euphoria are taking on crazy risks. But there’s little evidence that the market as a whole is in the grip of irrational exuberance.
Well-grounded bellwethers
A sure sign of a market bubble is when stock prices of companies race ahead of their profit growth. If we take the Nifty50 index (which accounts for 60 per cent of the overall market capitalisation and is the Indian market bellwether), its rise in the last five years has actually lagged the earnings growth of its constituent companies.
Between May 2019 and May 2024, the consolidated per share earnings of Nifty firms shot up from ₹488 to ₹1,010, managing a CAGR (compounded annual growth rate) of 15.6 per cent. The index value has risen at an annual rate of only 13.7 per cent. As a result, the Nifty price-earnings multiple at 22.6 times now is actually lower than it was five years ago (24.4 times). All numbers cited here are from Bloomberg, as of May 30, 2024.
Over a ten-year period, yes, the Nifty at a 12 per cent CAGR has sprinted ahead of the annual profit growth of 9 per cent managed by its constituents. But this seems to be at least partly because of the manifold rise in the liquidity flowing into stocks from domestic investors. MoSPI data show that Indian households invested over ₹2-lakh crore into shares and mutual funds in FY23 — a ten-fold surge from ₹18,900 crore in FY14. These flows have set a higher floor to India’s stock valuations. Even if they were to halve, valuations seem unlikely to go back to decade-ago levels.
Markets are usually forward-looking. Therefore, analysts usually gauge valuations using forward PE multiples based on estimated earnings for the next 12 months. On this metric too, the Nifty50 doesn’t appear pricey. The analyst consensus expects Nifty companies to clock earnings of ₹1,104 for the next 12 months, pegging the Nifty’s forward multiple at 20.5 times.
A second sure sign of a bubble is when market valuations soar way above historical averages. But the current Nifty PE of 22.4 is actually a tad below its 10-year average of 23.2. If we consider the 20-year average to iron out recent excesses, the historical average PE is 20. Previous bubbles — the dotcom boom of 1999-2000 and the capex euphoria of 2007-08 — were ready to pop at a Nifty PE of 25-26.
Company earnings can be propped up by windfalls or temporary tailwinds. That’s why many fund managers use the price to book value ratio (stock prices relative to companies’ net worth) as a more stable gauge of valuations. At 22,600, the Nifty trades at 3.7 times the current book value of its companies and 3.3 times their forward book value. The historical average is 3.2 times. Past bubbles saw this multiple scale 6 times.
The conclusion from all these fundamental checks is that a 40-50 per cent crash in the Indian bellwethers is quite unlikely. In the event of an adverse election outcome or other triggers, the Nifty PE multiple can correct to about 18-19 times. This would peg down the Nifty value to about 18,000 to 19,000, but not much more.
Frothy in patches
If the bellwether indices show few signs of froth, what about the broader market? This is a good question to ask because it is the tail-end of the market that is usually a happy playground for speculators.
The Nifty500 index, a broad market benchmark, offers some cues. The index trades at a PE of about 25.8 and a price to book ratio of about 4. This is pricier than the Nifty50. But it is not way off historical averages — a PE of 26.4 times and a price to book value of 3.2 times for the Nifty500.
But breaking down the Nifty500 into its constituents reveals that about 40 per cent of the stocks in it trade at a PE of 50 or above, while 10 per cent trade at 100 or above. The proportion of stocks trading at these astronomical valuations is also up sharply from five years ago. In May 2019, only 16 per cent of the Nifty500 stocks traded above a 50 PE and 3 per cent sported a 100 plus PE. This is where much of the froth is concentrated.
Running through the list of stocks at these nosebleed valuations, there were five common themes.
Low float companies: In a euphoric market, narratives help propel valuations. If tall narratives can be aided by the ability to corner liquidity because of limited free float, all the better. This trend has led to stocks with promoter holdings of 70 per cent or more turning into theatres for speculation.
Yes, many of these stocks do have fundamentals, but not enough to justify three-digit PEs and blue-sky growth assumptions.
Green theme: With policy tailwinds favouring renewables, it has been a field day for micro-caps with ‘eco’, ‘solar’, ‘energy or ‘green’ in their names. Many companies with these tags have managed to attain ₹500 crore to ₹1,000 crore in market capitalisation while turning in profits of less than ₹10 crore.
Midcap 150: The broad market benchmarks today are not steeply valued. But one exception, which looks quite bubbly is the Nifty Midcap 150 index — the benchmark for mid-cap mutual funds. For an index which is supposed to be an incubator for the Nifty50, it is a bit unreasonable for the Midcap 150 to trade at a PE of 39 times trailing earnings and 34 times one-year forward earnings — a premium to the Nifty50 itself. Also, 70 of the 150 stocks making up this index are already at a PE of 50 plus.
SME platforms: Usually in bull markets, penny stocks are the life and soul of the party. But this time, the partying seems to have moved off the main board, on to the SME platforms of the exchanges, where IPOs of mom-and-pop businesses have attracted frenzied bids. The BSE SME IPO index has raced at a 110 per cent CAGR over the last five years and trades at a 48 PE. The NSE SME EMERGE index after growing at a 53 per cent CAGR is at an 81 PE.
These are the market segments that investors need to be wary of, if they want to avoid the risk of those 40-50 per cent crashes.