Stretched valuations could weigh on Indian stock market returns in 2024, cautions CLSA

The valuations of the Indian stock market seem not only stretched, but India has become the most expensive large market in the world, which may weigh on returns this year, cautions foreign brokerage firm CLSA. In a report, CLSA noted that Indian equities started 2024 amid extreme bullish sentiment, with top decile valuations and a record discount to debt yields.

Notwithstanding India’s exciting long term growth story and the prospect of a third term for the incumbent government at the Centre, this stretched starting point may weigh on returns this year. “At 20.2x, the Nifty’s Price to Earnings (P/E) ratio has been higher on only 8% 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, but it is no longer the EPS growth leader that it has been for the past three years," said CLSA analyst Vikash Kumar Jain. CLSA believes that Nifty is trading at earnings multiples that have historically led to reversals.

“India is now the most expensive of the world’s largest markets and the only one trading in the top decile of its historical trading range. In fact, 15 out of the top 19 global markets are trading below their historical average valuations. This shows how stretched Indian valuations are in relative terms; it also emphasises the likelihood that any narrative or earnings growth disappointments could trigger a correction," CLSA report said.

Any improvement in the investment narrative of other large but cheaply priced Emerging Markets could force rotation of flows away from India. Moreover, the Nifty earnings yield discount to the Indian 10 year government security yield, at 2.2 ppts, also puts equity valuations relative to bonds at levels only seen on 3% of days since 2005, and is a position from which one and two year returns have historically been negligible.

The rally in the stock market of the past few months reflects rising confidence in a US soft landing. In this scenario, falling yields and a weaker US dollar should support more flows into emerging markets (EMs). Equity valuations at a premium to bonds in the US as well as India may drive a migration away from equities into bonds.

A significant growth slowdown or delays to further inflation cooling are risks for equities, CLSA noted. In this consensus soft landing scenario, a bigger share of foreign institutional inflows (FII) will come from non India dedicated funds, which should support mega caps over small /mid caps, it added.

The brokerage recommends being selective in the smallcap and midcap space. It prefers megacaps, banks, insurance and energy while our underweights are consumer and IT. It expects banks, L&T, Bharti Airtel and select material names to make an outsized contribution to the Nifty’s EPS growth and delivery on this will be crucial.

CLSA has laid out key strategy and economics themes for 2024 for the Indian stock market. Here are some of the key positive themes that will play out for Indian equities: : The Indian market is fairly deep, liquid and very well diversified compared with the EM cohort. There have seen strong inflows from India dedicated funds and going forward it is expected to see more stable inflows.

: The Reserve Bank of India is likely to cut rates in 2024 to maintain neutral real rates and prevent any growth shock. Domestic inflation has moderated and the Fed is likely to cut rates soon. : The rupee will strengthen in 2024 with the US dollar depreciating on Fed cuts. A moderating current account deficit and diminished FPI inflows will be further catalysts.

: Better growth prospects in India versus China have pushed India to outperform China in US dollar terms. However, a risk on environment could shift flows to laggards like China from India, given the extended valuation premiums. : FII inflows were strong, at $21 billion, in 2023, mostly from India dedicated funds.

Falling rates and a weaker US dollar will support inflows into EMs, which could flow down to India as well. However, valuation remains an overhang. : Ownership of domestic mutual funds have surpassed FIIs on the back of strong inflows at $22 billion. However, CLSA expects this to moderate due to attractive debt market returns.

: Participation has increased in the market. Their allocation to large caps have hit a multi year low. Any disappointment in Smids will hit retail investor sentiment. : Exuberance in the IPO market, in the final quarter of 2023, should carry on into 2024 as many fintech, EV, food delivery startups consider listings.

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