Leave the market to find its level

Leave the market to find its level

Since the Budget on July 5, the benchmark 30-share Sensex has shed 2%. It is 4% down from its all-time high of June 4. The usual reaction of governments faced with such downward movements is to nudge State-owned insurers, funds and banks to buy, and shore up indices. This time the government should do no such thing, and allow equities to drift down on investor sentiment. Falls are never bottomless: at some lower price, people will discover value and buy again. On the other hand, bailout buying by State-owned institutions will signal government fears, and make investors more jittery.

There are other reasons why it makes sense to let equities drift down. India’s market is now firmly in bubble territory. The price-to-earnings (PE) ratio measures how many rupees one has to pay to earn one-rupee profit from any company’s share. The higher the PE ratio, the bigger the price bubble around a company’s real earnings potential. For the 30 blue-chips comprising the Sensex, the PE ratio is now at a staggering 28, far higher than the 20-22 range that is considered safe. Last month, when the index closed at 40,000 points for the first time, this critical number was close to 30. These numbers are dangerously close to the all-time high PE ratio of 34 that was breached in March 2000 at the peak of the dotcom boom, which, of course, ended as a train wreck for all.

For most blue-chips, the last two calendar years have been poor in terms of profitability. Across sectors, from cement to pharmaceuticals, earnings per share (EPS) have been lower than in 2012, considered a year of chaos and policy paralysis under UPA-2. Instead of intervening directly in markets, the government should repair our financial infrastructure, restructuring banks, strengthening oversight and transparency.