Small detours on a one-way street

Indian markets seem to be on an upward trajectory. The last time Sensex and NIFTY 50 posted negative returns in a calendar year was in 2015. Indian indices had rallied even in 2020-2021 when India posted negative economic growth of -7.3% due to the COVID-19 pandemic. Similarly, the index delivered positive returns in 2022 despite large outflows by foreign portfolio investors of about $18 billion due to rate hikes by the Federal Reserve. The resilience of Indian equities has been a function of strong earnings growth and domestic venture capital flooding into the markets.

The NIFTY 50’s forward P/E of ~21.0x (Jefferies, Sept. 6) is about 3.0x higher than its 10-year average. This can be explained by political and macroeconomic stability, corporate balance sheet deleveraging, and a strong capex cycle driving earnings. While valuations of large-cap companies appear justifiable, much of the froth in Indian markets is concentrated in small- and mid-cap companies. The NIFTY MidSmallCap 400 index trades at a P/E of ~38.6x, which is 13.0x higher than the trading multiple exactly a year ago (~25.4x). This suggests that price increases are predominantly driven by multiple expansion rather than corporate earnings growth, unlike for larger Indian companies.

However, there seems to be no end to this story across the market cap spectrum as long as domestic capital flows remain strong. As of August, assets under management (AUM) for equity schemes had crossed Rs. 30 lakh crore or ~$357 billion, up from ~Rs. 2 lakh crore in 2014. While the share of domestic retail and institutional investors (DIIs) in equity ownership (in NIFTY 500) has increased post-pandemic, foreign portfolio investors (FPI) ownership has been on a steady decline, hitting a 12-year low at 18.8%.

If we look at the free float statistics, the numbers are even starker. FPI free float ownership has come down to 39% (from a peak of 48%), while domestic investors now control 53%, of which DIIs are 35% and retail investors 18%. FPIs are generally considered more volatile than DIIs because the latter are relatively indifferent to currency-related risks. Consequently, the volatility profile of Indian markets has also come down significantly (see chart below), creating the perfect combination for investors of high returns with lower volatility.

Naturally, the question then arises: what catalyst or set of conditions can create deviations in this one-way street? While the long-term fundamentals supporting the Indian stock market story remain strong, investors in the stock market need to be wary of corrections (drops of more than 10%) that tend to be more likely with high market multiples, implying elevated expectations on the part of investors. Four short-term risks include:

1. Slower earnings growth in Q2: In Q1, NIFTY 50 index net revenue grew by only ~5%, with some laggard sectors like IT services and consumer beating expectations. On a broader level, BSE 500 index companies (excluding oil marketing companies) grew their top and bottom lines by 8-10%. Interestingly, BSE 500 index companies that reported negative earnings rose 46-62% in the June quarter. However, FY25 annual estimates for earnings per share (EPS) growth are much more aggressive and stand between 15-19%. Hence, expectations for the remaining three quarters of FY25 remain elevated. In the first quarter, even moderate earnings that beat expectations (e.g., IT sector) were rewarded strongly by the market, while big disappointments (e.g., Asian Paints and Jindal Steel) were ignored. Going forward, one or two more quarters of relatively weaker earnings could create the potential for a re-evaluation of the high multiples offered by Indian markets.
2. State Election Results: The October-November period will see four key state elections – Maharashtra, Jharkhand, Haryana and Jammu & Kashmir. During the general election period, a significant rise in volatility was witnessed with the VIX index reaching a high of 26.75 from a low of 10.20. Elections predominantly impact markets in two ways – i) policy stability and ii) government spending priorities. In the scenario where the BJP faces a severe setback in states like Maharashtra and Haryana, a more challenging overall political landscape may have negative repercussions on markets. Assumptions of higher revenue expenditure in subsequent budgets will rise, with a possible return of fiscal recklessness.
3. Increased supply/more stock sales: There is an insatiable demand for new securities in the Indian equity markets, as evidenced by the over-demand seen in IPOs. Bajaj Housing Finance’s recently concluded IPO is a clear example, with ~63x over-demand on a ~$780 million offering. Moreover, mutual funds have record cash reserves of Rs 1.7 lakh crore (~$20 billion), which they are opportunistically deploying. On the supply side, over $28 billion was raised in Indian equity markets in the first half of 2024, which is ~200% higher than the same period in 2023. Several companies are using this opportunity to go public. Also, promoters and the government could leverage the high valuations through secondary sales. In India, private promoters hold ~41% of the shares listed on the BSE 500, which is significantly higher than developed equity markets like the US. As insiders and affiliates start selling their stakes, the balance could tilt in favour of supply, leading to a correction.
4. Worsening of the global macroeconomy: In a recent report, JPMorgan put the probability of a global recession at 35%. Leading indicators in the US continue to suggest a slowdown in the US economy, with the LEI index still trending lower. While the recent cooling of US CPI inflation to 2.5% suggests that a “soft landing” is not out of the question, any severe macroeconomic slowdown will have a negative impact on Indian markets. This is happening due to i) the flight of foreign capital to safer havens like Treasury bonds, and ii) the reduction in corporate profits of companies selling abroad.

Interestingly, there have already been a few negative catalysts in 2024 that could have triggered a more sustained correction. Examples include the reversal of the Japanese carry trade (August 5), the Indian general election result that fell short of expectations (June 4) and the capital gains tax hike in the Union Budget (July 23). However, the market brushed these aside and quickly recovered. Mutual funds, sitting on record cash, are deploying capital in every minor correction, thereby stabilising the markets. These are truly unprecedented equity market conditions given the influx of retail money, suggesting that we may not see a sustained correction even if the aforementioned risk factors materialise.

Contributed by: Dhruv Goyal

Disclaimer: The views and opinions expressed in the article are those of Dhruv Goyal, CEO, FourLion Capital, and are offered for general information purposes only. The views and opinions expressed in the article are not those of ET.