On Wednesday, the Dow Jones index cheered Donald Trump’s first address to the Congress with a vault over the 21000 hurdle. The US president was quick to point to Dow’s steady gain of USD 3 trillion since he took office on November 8, 2016 — a date which coincided with India’s move to ban Rs 500 and Rs 1000 notes.
Indian markets too have had a spectacular rally during the same period. But such spikes often came with a lag time. Both Trump’s victory and demonetisation proved too much for the Indian markets as they took a month to recover from the double shock after making its bottom of 25,753 on December 26, 2016. Since then Indian markets, however, have recovered 12.75 percent as compared to a 15.18 percent rally on the Dow.
While US markets are factoring in strong future growth after Trump’s pledge to spend USD 1 trillion in infrastructure, our rally doesn’t have legs, claim pundits. And they could be right. Here is why.
Price to Earnings
In spite of a bigger move the Dow is trading at a price to earnings of 21.18 but at these levels its dividend yield is 2.32 percent as compared to its 10-year treasury yield at 2.467 percent. In other words a risk-free asset is roughly giving the same yield as a riskier asset — equities.
Compare this to the Indian scenario. BSE Sensex trades at a comparative price to earnings ratio of 22 with a dividend yield of 1.42 percent, while India’s 10-year treasury yield stands at around 6.871 percent. However, India’s dividend yield has historically been at a big discount to its treasury yields trading in a band of 1 and 2.5 because of a higher growth rate as compared to US.
Though valuations are similar in both the US and India on a historical basis, it’s the future growth that will drive markets. This is where the problem lies for India.
US markets are rallying on account of an expectation of a corporate tax cut, deregulation, government spending and higher employment. US PMI survey shows that American corporates are expanding at break-neck speed.
In India the situation is exactly the reverse. Factory output and government data show there’s been no pick-up in private sector investment. Government spending is the only driver for capital spending. Corporate tax cuts have been promised but not delivered for the last three years. This year the Budget tweaked rates for smaller companies. The government continues to struggle with job creation.
Finally, apart from valuation what drives markets is liquidity. Foreign institutional investors had been selling Indian stocks continuously for four months from October 2016 to January 2017. The selling tapered down sharply in January, which helped the market rise on continued support from domestic mutual funds. Domestic institutional buying slowed in February but thankfully FIIs bailed the market out by pumping in Rs 10,455 crore in the month.
How foreign investors will act going forward especially after a clarity on US economy emerges is a bigger worry now. Ongoing state elections results will have a bearing on government’s path for development. For them the US markets offer a better risk-reward ratio as risk for investing in Dow is nearly the same as investing in a government bond.