Foreign brokerage CLSA has cautioned that the top-decile valuations of Indian equities may weigh on returns this year, notwithstanding the prospect of a third term for the incumbent government at the Centre.

At 20.2x, the Nifty’s price to earnings multiples have been higher on only 8 per cent of days over the past 18 years. The market’s valuation premium to its historical average is the highest recorded among the 19 largest global markets and India is no longer the EPS growth leader that it has been for the past three years. India’s valuation premium to China, for instance, is close to 14-year highs. The brokerage’s proprietary India bull/bear index has had an extended 95 per cent bullish sentiment reading as well.

“A delayed cool-off in inflation and dramatic growth slowdown in the US could raise fears of recession and will be negative for global equities, including India. A risk-on environment, on the other hand, could shift flows to laggards like China from India, given the extended valuation premiums,” CLSA analysts said in a note.

Retail investors’ direct ownership in the BSE 500 stocks has climbed to over $300 billion. Their allocation to small caps is at a multi-year high of 15.9 per cent. At 21 per cent, their ownership of mid-caps is nearing the previous high of December 2021. Their share of large caps has fallen to multi-year lows of 63.1 per cent.

“Given stretched valuations and extended ownership, we recommend investors remain selective in SMIDs. Any disappointment in this space could hit retail investor sentiment,” the brokerage said.

The Nifty earnings yield discount to the Indian 10-year government security yield, at 2.2 percentage points, puts equity valuations relative to bonds at levels only seen on 3 per cent of days since 2005. This is a position from which one- and two-year returns have historically been negligible. The Indian equity risk premium has fallen to 5.1 per cent versus the long-term average of 5.4 per cent.

CLSA emphasised shifting to debt from equity with better return potential for bonds given the tailwinds in the form of rate cuts by the RBI (up to 100 bps) and inclusion of Indian bonds in the JP Morgan index. “This may draw retail money away from equity markets and limit Nifty’s upside,” it said.

Positives

Falling interest rates and cool-off in the US dollar could be potential tailwinds for EMs as an asset class this year. This may drive a rise in inflows into EM funds, some of which could trickle down to the Indian market, especially mega and large-caps, despite its premium valuation.

Despite record flows, FPI ownership of the BSE-500 stocks stood at 18.1 per cent, close to the decadal low of 17.9 per cent seen in September 2022 and way below the highs of nearly 21 per cent seen less than three years ago.

Non-India dedicated foreign funds account for 93 per cent of the total FPI AUM in India. However, India dedicated funds contributed an estimated 75 per cent of the total FPI flows last year. “This may be a sign of recognition for India’s deep, broad and liquid market over and above its economic potential to attract money on its own,” the brokerage said.

With a total market cap of $4.2 trillion, India was a highly liquid and sectorally well-diversified market. It has 173 large-caps with a market cap of more than $5 billion, more than any other country except the US, China and Japan. India has 259 stocks that trade over $10 million/day, ranking it fourth globally. The top two sectors account for a 40 per cent weight in India’s benchmark index, one of the lowest numbers among EMs and compares with over 85 per cent for Taiwan at the other extreme.

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