Indian Stock Markets Hits Bubble Zone, Correction Imminent – Experts

The Indian stock markets are flying high, with the benchmark Nifty 50 index having nearly doubled from its March 2020 lows. The Sensex has also hit multiple record highs this year. However, this incredible rally has pushed valuations to record levels, raising concerns if the market is overheated.

Stretched Valuations Across Indian Stocks and Indices

The Nifty currently trades at a trailing 12 month PE ratio of 26.8 times compared to its 10-year historical average of 18.5 times. The Sensex PE is at similar elevated levels of 27 times against its historical average of 19 times.

The PE ratio measures how much investors are willing to pay for each rupee of earnings or profits of a company. The higher the PE ratio, the more expensive stocks are relative to their earnings.

Historically, periods of high PE ratios are followed by lower than average market returns over the subsequent 5-10 years. This is because when investors bid up valuations due to euphoria or speculation, future returns tend to come down as valuations eventually mean-revert.

As per a Credit Suisse research report, the Nifty delivered 9% annualized returns over 10 years when starting PE was between 12-14 times. But returns fell to just 5.5% annualized when starting PE was above 22 times.

“High PEs signal lower expected returns over the long term as valuations get stretched. Reversion to the mean impacts future market returns”, explains the Head of Product Development and Strategy at a major mutual fund in Mumbai.

The inflation in valuation is driven by similarly irrational stock valuations. For example, Hindustan Unilever (HUL) now trades at PE of 80 times compared to between 30-40 times historically. ITC’s valuation multiple has nearly doubled from 15-16 times historically to over 32 times now.

“Consumer stocks like HUL and ITC trading at such huge premiums to historical valuations clearly signals euphoria and stretched valuations across the market”, notes another Fund Manager.

The mid and small cap indices are also not far behind with Nifty Midcap 100 trading at PE ratio of 33 times compared to its long term average of 20 times. Valuations appear rich even when comparing to other emerging markets.

Expensive Compared to Other Emerging Markets

The MSCI Emerging Markets index currently trades at a 12 month trailing PE of just 12.8 times. This is less than half of Nifty’s valuation of 26.8 times. Even compared to its own historical average of 14.4 times, the emerging markets index looks reasonably valued.

China’s Shanghai Composite trades at PE ratio of just 11.3 times which is less than half of Nifty’s current valuation. Brazil’s Bovespa index trades at PER of 9.4 times.

“India is clearly an outlier when compared to broader emerging markets in terms of valuations. It reflects the market’s expectation of superior earnings growth in India relative to other EMs”, said the fund manager.

Trading at Premium to Developed Markets

Remarkably, the Nifty now trades at valuation premium to even developed market indices like FTSE 100 and CAC 40.

The UK’s FTSE 100 index is trading at PE ratio of just 12.9 times. France’s CAC 40 index is at PE of 13.6 times. The Nifty is thus trading at more than double the valuation of these developed market peers.

“The fact that India now trades at PE multiples higher than developed European indices signals potential overvaluation. The premium versus EMs and DMs looks unjustified”, points out another Mumbai-based equity strategist.

Historically, India has always traded at a valuation discount to developed markets given lower per capita income. The current premium is a departure from historical trends.

Stretching the Growth Boundary Assumption

What explains the exceptionally high valuations for India vs global peers?

It appears that the market is pricing in stellar earnings growth for Nifty companies relative to rest of the world. But estimates look stretched.

The Nifty earnings per share is expected to grow at 18-20% CAGR over next two years as per analyst estimates. However, India’s nominal GDP growth is only expected to be 10-12% CAGR.

“Expecting Nifty EPS to grow at almost double the nominal GDP growth looks too optimistic. Some moderation in growth assumptions looks likely which could lead to a reset in valuations”, said an mutual fund industry veteran.

Thus, current valuations appear to be factoring in extremely bullish expectations which leaves little room for disappointments or slowdown in growth.

Conclusion – Market Looks Overheated in the Near Term

In summary, current Indian market valuations appear over-stretched relative to its own history as well as compared to global peers across emerging and developed markets. The rally has largely been liquidity driven thus far.

While India’s growth story remains intact for the long run, valuations look overheated in the near term. Some correction or consolidation looks imminent after this strong run-up. Investors would do well to moderate their return expectations and be selective in adding stocks at these levels.