July 2017: 3 characteristics of a bull market peak

With the Nifty scaling the 10,000 mark, several investors have concerns as to whether the market is beginning to get overvalued and whether we are approaching a bull market peak. Typical bull market peaks are characterized by high earnings growth in recent years, high corporate profitability and high valuations as measured by some standard metrics like ‘Price to Earnings’, ‘Price to Book value’, etc. Let us examine how these factors stack up in the current bull market in Indian equities.

Aggregate earnings growth for the Nifty has been fairly poor in recent years. The aggregate earnings growth of the Nifty over the last 5 years is close to 6%, which is significantly below its historical average growth of 12-14%. Part of this can be attributed to the low inflation in recent times – this has had an impact on the nominal growth and hence the reported numbers. Volume growth being reported across industry segments is below trend.

We try to get a sense of aggregate profitability of the corporate sector by looking at the Return on Equity (RoE) reported for the Nifty 50. Currently the median Nifty company’s RoE is at 14.6% which is the lowest recording for this parameter over the last 18 years. The current economic cycle peaked roughly around the financial year ended 31-Mar-12 and we have now seen an economic slowdown for nearly 5 years. This is also the period when there have been some short term disruptions caused by demonetization, GST and implementation of RERA. Many of these will be good over the long term but the economy needs to take a short term hit.

On the valuations front, the aggregate valuations are now above the median of the tops recorded historically, as the Nifty is trading close to 26x trailing 12 months earnings. This is the one signal that is flashing red on our monitors and does bear watching. The low RoEs discussed earlier are a mitigating factor to the high valuations, which suggests earnings growth should be faster in the coming years as the economy recovers. Yet one can’t get away from the fact that many stocks, especially in the mid-cap and small cap category are beginning to see some levels of froth build up, which can be a cause for worry for investors in these situations.

What we have observed right through this bullish phase in the market is that it has remained very stock selective. For a bottom-up stock picker, it has been a good period because one has seen a reasonable number of stocks available at sensible prices to build a quality portfolio. That balance is beginning to get disturbed a bit now, as we are finding it increasingly difficult to populate new portfolios as compared to the past. Our mature portfolios still have low cash because the stocks we own have still not reached their sell points but if the current market trend continues we may look to pare some holdings in order to reduce risk in the portfolio.

However at the big picture level, since only one of the three conditions for a bull market peak, is satisfied ie of high valuations, we would believe that the market is anticipating growth to come through over the next few years on a cyclical basis and we are not close to a bull market peak yet. Yet, it may be time for investors to be cautious and have a good look at the stocks they own and whether their valuations are reasonable.