Why is the stock market doing so well?
The BSE Sensex and the NSE Nifty are at record high levels, gaining well over 20% this year. The Indian economy’s high growth rate has been touted as the major reason behind the rally. The belief is that high economic growth should lead to higher earnings, thus supporting higher stock prices. But other stock markets across the globe have experienced equally impressive gains. So the present bull run could be better explained by the flow of huge capital into the stock market.
How is liquidity affecting the market?
Central banks around the globe have been on a money-printing spree since the crisis of 2007-08, which has distorted the prices of financial securities. New money pouring into the capital markets has bid up the prices of various securities, including bonds and stocks. In such an environment, risk-averse investors unwilling to pay a high price have been priced out of the market. At the same time, risk-seeking investors who are ready to pay through their nose have remained in the market.
Is the market overpriced at current levels?
Corporate earnings and interest rates determine the price of stocks in the long run. Prices fall if they are out of touch with either of these fundamentals. On the earnings front, the Sensex’s price-to-earnings ratio based on trailing earnings is close to 23, higher than its historical average of around 18.
Given that earnings growth has been flat in recent years, it may be premature to justify current prices based even on future earnings growth. On the front of interest rates, low rates have been the only reason justifying current stock prices, but whether they can stay low forever is the big question.
What are the riskiest stocks?
Mid-cap and small-cap stocks have seen a greater percentage increase in their prices, thanks to investors aggressively pricing in future earnings growth. If future earnings fail to keep up with expectations, already factored into their prices, we could see a sharp fall in their prices.
There is significant risk involved here as many of these companies lack a strong track record of sustainable earnings, which increases the chances of an earnings surprise in the future.
Is a serious crash imminent?
It is hard to predict the market’s next move. Corporate earnings have failed to recover sufficiently to keep up with rising prices, so that is one major risk. A rise in interest rates is another risk, as when central banks stop pouring money into the market, it could affect stock prices adversely.
