The benchmark indices have rallied almost 7 to 8 per cent in two trading days, ever since the government announced a cut in the corporate tax rate.

Is a 8 per cent rally in the Nifty (nearly 800 points) since the announcement really warranted?

The rally is justified

The markets are slaves to earnings and when earnings grow, there is a reduction in the existing price to earnings multiples, which is when markets start gaining ground.

Let us give an example. The one year forward p/e of the Nifty was around 19 times, before the announcement of the corporate tax cut. Now, when there is a tax rate cut, the earnings grow and so does the EPS.

There are reports that suggest that the cut in corporate tax rates, would add around 7 to 10 per cent to the Nifty EPS. If this is true, then the indices should rally by a similar per cent, which it has done. A cut in corporate tax rate, directly impacts most corporate bottom line.

So, while the rally in the Sensex and the Nifty are justified, of nearly 8 per cent, a further rally would largely depend on how earnings growth takes place.

Other benefits that come with a cut in the corporate tax rate

There are other benefits that come with a corporate tax rate cut. The belief is that higher net profits of companies would lead them to increase private sector investment, which in turn would propel growth. However, this maybe a little far-fetched to hope for, given that private sector investment is unlikely to materialize, unless the demand environment changes significantly. Demand in key sectors like auto, construction and real estate has virtually collapsed and unless demand revives, we are unlikely to see a fresh impetus to the economy.

At the moment, it is unlikely that the demand environment will change, given low rural wages and unemployment. So, if companies despite increase in profits, due to the cut in the tax rates, decide to distribute it by way of additional dividends etc., it might only create more shareholder wealth.

Is it a good time to buy shares now?

At the moment shares have rallied significantly, and it would not make sense to buy into stocks. A dip of about 2-3 per cent from these levels, should make shares attractive. However, that may not happen, unless there is some large scale selling in the global context.

At the moment, it is a good idea to just stay invested and also not sell, despite the strong rally. Remember, that most stocks have not rallied and the present rally is in the large index stocks, and bulk of this is led by HDFC Bank. So, it might take time for the broader markets to rally, especially the large and midcap stocks. So, until then it would be a good idea for investors to just stay invested in the markets and not sell. We anticipate that the rally in stocks could continue even further in the coming days. Those with a long-term perspective may want to buy into good dividend paying companies.

GoodReturns.in