“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair…”

The opening lines of Charles Dickens’ novel A Tale of Two Cities—referring to the contrast between London and Paris, where chaos reigned ahead of the French Revolution—pretty much sums up the Indian economy and the stock market in a world reeling under a pandemic.

Look at the irony! While FY21 was the worst year for the economy since Independence, it was the best-ever year for equity investors. The benchmark Nifty 50 rose 72% in FY21 as India’s GDP shrunk 7.3% during the period.

Defying the pandemic—and its debilitating impact on the Indian economy and businesses—the Indian equity market has been one of the top performers globally in the post-pandemic period. Over the last 12 months, global market capitalisation (m-cap) grew by 44.3% to $110 trillion, while India’s m-cap rose 67% to $3 trillion. Its share of global mcap now stands at 2.8%, higher than its historical average of 2.4%. In contrast, India’s share in world GDP declined to a four-year low of 3.1% in FY21 from 3.3% a year ago.

As a result, the Indian equity market remains one of the most expensive in the world, with the BSE Sensex trading at a trailing P/E multiple of 31.3x, nearly 20% higher than its pre-pandemic valuation. But what goes up must come down.

When Does The Party End?

In the past month, benchmark indices have stayed range-bound, signalling fatigue among bulls. Is there a bubble building? A host of analysts remain bullish and expect the markets to go even higher. They believe that stock valuations don’t matter anymore and what’s important for the markets is the incremental growth in corporate earnings and the monetary stance of the world’s major central banks, especially the U.S. Federal Reserve.

But here’s the catch. It’s not going to be a party that never ends. “If there is one concern, it is inflation across all emerging markets. Mexico has started raising rates, Russia and Colombia are also considering raising rates, and India is one of the few countries still talking about an accommodative monetary policy. If that narrative were to change earlier than expected (before the first quarter of the next fiscal), and if inflation and oil prices continue to remain high, there can be an issue,” says Amit Shah, head of India Equity Research at BNP Paribas.

Retail inflation was 6.26% in June, above the Reserve Bank of India’s threshold of 6%, driven by rising fuel and food prices. “Till now, nobody was complaining about higher pump prices, but they are now beginning to translate into an inflationary impact because consumption is going up,” says Shah.

The upside risks on inflation are growing from surging global commodity prices, especially crude, says Dharmakirti Joshi, chief economist, CRISIL. “While producers are bearing a greater burden of rising input costs for now, these will get passed on to retail prices once demand recovers.”

Companies have already started passing on the rise in input costs to retail customers; for example, Maruti Suzuki, Hyundai India, and Honda Cars India have already revised prices upwards twice in 2021.

The price of Brent crude has risen by over 45% to $75 per barrel, from $51.8 a barrel at the beginning of 2021, following a surge in global demand. “Resurgence in crude... can have a long-term inflationary impact. We recently had our third-quarter outlook, and our global teams bumped up inflationary expectations for almost every country,” says Shah.

Risks Building Up With GDP Contraction

Inflation, however, is not the only risk to the bull run. A mix of record-high valuations and a strong possibility of lower-than-expected GDP growth, besides a hit to corporate earnings in FY22 following the second wave of the Covid-19 pandemic, raise downside risks for equity markets in the coming quarters. “The risks of another wave and tardy vaccinations mean states would be chary of fully unlocking anytime soon. That is unlike what we saw [in the] last fiscal when a largely uniform and calibrated reopening spurred a sharp recovery,” says Joshi.

CRISIL has lowered its GDP growth forecast for India to 9.5% for the current fiscal, from the earlier 11%. The stock market, however, remains upbeat about corporate earnings going forward.

There are two ways to look at corporate earnings, says Vinod Karki, head of strategy, ICICI Securities. “If you look at the overall profitability of India Inc., then it is coming off a two-decade low. Even during the pandemic year, despite all the challenges, profit (after tax) to GDP ratio improved to 2.8%, driven by cyclicals,” he says.

From a technical perspective, the earnings are going up from a very low base, driven largely by corporate banks, metals, infrastructure, and telecom, which have witnessed losses in the recent past. “This tendency will continue because, in the next few years, earnings will normalise in a lot of depressed sectors,” says Karki.

According to Shah, the Nifty’s earnings outlook for FY22 and FY23 is an average 14%-14.5%. And though it appears that the market doesn’t warrant the multiple at which it is trading now, it has been selective in the way stocks have rallied: sectors like IT and pharma are up, “while companies exposed to travel or tourism, restaurants or discretionary plays have been underperformers, along with consumer retail”, he says.

Taper Tantrum Risks

The other major risk is a pause or stop to quantitative easing. The pumping in of money by central banks to ensure purchasing power in the hands of people has been unprecedented. JPMorgan Chase projected that the balance sheets of central banks will have grown by $11.7 trillion during 2020-21, and, by the year-end, their combined size will be $28 trillion.

And that’s where the worry lies. What happens if the tapering begins earlier than expected? “Tomorrow, if they surprise the market by announcing an immediate reversal to quantitative easing, then it can come as a shock. But as long as their credibility is maintained, we do not see any shocks,” says Karki.

What if the markets crash or correct? There will be an initial sell-off when the tapering begins, says Shah. “But because it is so well-communicated, the impact should be materially lower than what we saw in the 2013 taper tantrum.” Then there are Black Swan events. “I don’t visualise a major crisis in the short term. But if at all the market crashes, it is going to be a big pain for the small-caps followed by mid-caps,” says G. Chokkalingam, founder and managing director of Equinomics Research & Advisory.

Stock markets operate in cycles marked by either over-performance of small- and mid-caps (as is the case now) or good returns from large-caps, as it happened between December 2017 and March 2020.

Small-caps have outperformed the Sensex by a factor of five since the beginning of 2021. The BSE Small-Cap Index is up nearly 46%, while the BSE Mid-Cap Index is up 28%. In comparison, the benchmark BSE Sensex is up just 10% year to date. “Whenever small-caps outperform the Sensex by a big margin, they see severe correction the following year. That is because their relative valuation becomes expensive,” says Chokkalingam. As a result, investors tend to book profits and move away.

That’s more so because investors with a one-year horizon usually put money into small-caps, which sees very little institutional investment. “When profit-booking happens in small-caps, liquidity dries up fast because mostly short-term money is invested. So the shift from highs to lows can happen very swiftly,” says Chokkalingam.

The BSE SmallCap Index is trading at a valuation premium of 63% over the Sensex and a 25% premium over the mid-cap index, as of July 22. It is currently trading at a P/E of 53x, while the mid-cap index is trading at a P/E of 42x.

Karki attributes the high headline P/E multiples to abnormally low profits and losses incurred by many small firms during the pandemic, also called loss pool in market parlance. For FY21, in the Nifty Smallcap 100 index, the loss pool contribution was a negative 53% (-53%) to an aggregate profit base of `7,600 crore, while in the mid-cap space, it was -42% to an aggregate profit base of `32,300 crore. For the Nifty 50 index, the contribution to the loss pool was just about 2%.

Shah agrees that in an “unlikely event of a crash”, the small- and mid-cap stocks can see a sharp correction. That’s because liquidity and investor sentiment play a big role in the valuation of second- and third-tier stocks.

Since usually retail investors invest in small- and mid-caps, they tend to book profits and move away at the first opportunity. “Retail investors have made a fair bit of money... when the economy opens up, will many of these investors book some profit to spend on discretionary goods and services? If that happens, the impact will be mostly felt in the mid- and small-cap segments,” says Shah.

Alongside, analysts say that large-caps won’t be much impacted. “If small-caps fall by 40%, large-caps may fall by only 5%-10%,” says Chokkalingam, adding that the possibility of a decline in large-caps is because some stocks are trading at a P/E of 100, which isn’t sustainable. For example, two of India’s biggest retailers, Avenue Supermarts (DMart) and Titan, are trading at P/E multiples of 188x and 159x, respectively, even as their revenues and profits—stagnant for the past two years—are expected to be hit in FY22 because of the second and likely third wave. At the other end of the valuation spectrum, NTPC is trading at a P/E of 8x while Power Grid is available at just 10x of its FY21 earnings. “The money which flows out of expensive stocks can chase relatively cheaper valued stocks. So the overall market cap within large-caps may not fall,” says Chokkalingam.

The Crisis Strategy

There’s unanimity on what to do if there is any correction. “The crisis, if it comes, will be an opportunity for a bottom-up approach,” Chokkalingam says. Bottom-up investing focusses on analysing individual stocks instead of being swayed by macroeconomic and market cycles. Investors will have to focus on a company’s fundamentals, management commentary, future outlook, and business stability before investing. Ideally, one should go for industry leaders trading at a discount to the valuation in the broader market.

Chokkalingam suggests applying four filters, especially for mid- and small-caps: management quality should be good; the companies should have the least amount of leverage; there should be no major pledging by promoters; and the stocks should give valuation comfort.

Analysts say investors should look at small- and mid-cap companies that are potential acquisition or investment targets for global private equity and venture capital funds.

While there is no imminent reason for the markets to crash, but in the event they do, it should be viewed as a buying opportunity, says Shah. “This is because India still remains one of the fastest-growing economies globally despite the second wave. And despite higher inflation, Indian monetary policy remains accommodative.”

History is, however, not kind to those who invest at the peak of a valuation cycle. The post-pandemic returns seem juicy because the valuation of the Sensex had plummeted to a seven-year low of around 17x while India’s m-cap-to-GDP ratio had hit a decadal low of 55% in March 2020. This steep decline created the space for a subsequent V-shaped recovery in stock prices. Now, all valuation metrics are at record highs.

Investors also face downside risks from lower-than-expected corporate earnings in FY22, and an adverse risk-reward ratio for equity as interest rates rise and the rupee depreciates. Given that even if the broader market doesn’t crack as no one expects central banks to take away the punch bowl in a hurry, the returns from equities won’t be juicy either.

The author is co-founder and editor of 30Stades.com.

Follow us on Facebook, X, YouTube, Instagram and WhatsApp to never miss an update from Fortune India. To buy a copy, visit Amazon.