Evaluating the macroeconomic linkages with equity markets in emerging economies

Abstract

With BSE Sensex’s estimated price-to-earnings ratio breaching 24-mark 1 (similar expensive valuation was prevalent during 2007-08 prior to global meltdown wherein Sensex’s estimated P/E clocked 22.61), the Indian equity market is trading at an all-time-high. Despite the growing concerns of the markets being expensive and anticipating a correction in near term, prices remain elevated with no correction in sight. Along with investors’ optimism, one of the fundamental reasons leading to market surge is the excess liquidity in the economy due to varied inflation expectations, fiscal policies and global factors affecting foreign equity inflows. Having mounted around 24%2 this year, Nifty surpassed the 10,000-mark for the first time since inception. According to a Bloomberg report, Nifty’s estimated P/E is nearly couple of standard deviations above its 10-year mean. The only time numbers look so stretched was before the 2008 landslide in equity prices. The Sensex trading at 33,000 plus mark when corporate earnings are flat for last three years speaks much about the pervasive euphoria in the market. One of the primary reasons behind such astronomical rise in stock prices without underlying fundamental factors contributing is largely due to the excess liquidity in the system. Thus, the valuation appears to be stretched for the moment and it is pertinent to analyze the deviation from the true market economy and the factors contributing to the same. Hence, this report aims to identify the macroeconomic factors that drive financial markets in a country, particularly Indian equity markets. Furthermore, this study also attempts to arrive at an intrinsic valuation of the equity markets of the emerging economies under consideration and make a relative comparison across them. This report also talks about the rationale behind market exuberance locally and moreover an effort to understand the correlation between macroeconomic linkages through Fed model.