Robust earnings, GDP growth key to sustain stock valuations

Robust earnings, GDP growth key to sustain stock valuations
Highlights

Growth in the economy as well as corporate earnings is required to sustain the current stock market valuations, otherwise the possibility of a correction cannot be ruled out, the Economic Survey said on Monday. 

New Delhi: Growth in the economy as well as corporate earnings is required to sustain the current stock market valuations, otherwise the possibility of a correction cannot be ruled out, the Economic Survey said on Monday.

The higher valuation in the stock markets could be due to fall in the equity risk premium (ERP) reflected in a massive portfolio re-allocation by savers towards equity in the wake of policy-induced reductions in the return on other assets.

ERP, in market parlance, refers to the extra return required on shares compared with other assets. "But 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. Otherwise, the possibility of a correction in them cannot be ruled out," the Economic Survey 2017-18 noted.

Over the past two fiscals, the Indian stock market has soared, outperforming many other major markets. Since end- December 2015, the S&P index has surged 45 per cent, while the Sensex has climbed 46 per cent in rupee terms and 52 per cent in dollar terms, leading to a convergence in the price- earnings ratios of the Indian stock market to that of the US.

Explaining this convergence, the Survey said expectations of earnings growth, which lie at the origin of the stock market boom, and demonetisation have given impetus to the phenomena. According to the Survey, the price of an asset is not solely determined by the expected return on that asset. It is also determined by the returns available on other assets.

"As pointed out in last year's Economic Survey, the government's campaign against illicit wealth over the past few years exemplified by demonetisation has in effect imposed a tax on certain activities, specifically the holding of cash, property, or gold. Cash transactions have been regulated; reporting requirements for the acquisition of gold and property have been stiffened.

"In addition, rupee returns to holding gold have plunged since mid-2016, turning negative since mid-2017. In addition, previously, stock prices had suffered because reporting requirements were higher on shares than purchases of other assets. But the attack on illicit wealth has helped to level the playing field," the Survey noted.

It said that all these factors have caused investors to re-evaluate the attractiveness of stocks. Accordingly, they reallocated their portfolios toward shares, with inflows through stock mutual funds, in particular. This has helped in decline of the ERP.

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