Economic strength or extreme euphoria: What's driving Indian stock markets?

Valuations in most parts of the Indian stock market, analysts said, are expensive with the extent of overvaluation increasing in inverse order of market-cap, quality, and risk

The Indian stock market continues to be a mix of optimism and euphoria, said analysts at Kotak Institutional Equities, with some parts rightfully reflecting the strength in the economy and its long-term growth prospects, and other parts reflecting extreme euphoria linked to baseless narratives with absolutely no linkage to fundamentals.

“The market continues to be a three-part market with sectors such as financials trading at reasonable valuations; sectors such as consumer, IT services and pharmaceuticals trading at full-to-rich valuations; and sectors such as automobiles, capital goods and public sector undertakings (PSUs) trading at euphoric valuations,” wrote Sanjeev Prasad, co-head, Kotak Institutional Equities (KIE), in a recent note co-authored with Anindya Bhowmik and Sunita Baldawa.



Valuations in most parts of the Indian stock market, these analysts said, are expensive with the extent of overvaluation increasing in inverse order of market capitalization (market-cap), quality and risk.

 

“In general, large-cap stocks are less overvalued compared to mid-cap and small-cap stocks, high-quality stocks are less overvalued versus low-quality stocks, and low-risk stocks are less overvalued compared to high-risk or ‘narrative’ stocks,” the KIE note said.

Poll outcome scenarios

Investors, KIE believes, are perhaps emboldened by solid long-term growth prospects of India and spectacular developments over the next few weeks, once the new government (likely the same BJP/NDA government) presents its economic agenda for the next five years.

In its most optimistic scenario, Prasad expects the BJP/NDA to form the next government with BJP at 325+/- seats and NDA at 375+/- seats.

The market, he said, is likely to view this outcome quite favorably and will have high expectations of acceleration in economic reforms in general with continued thrust on economic liberalisation (ease of doing business), major policy changes in areas such as labor and land and sectors such as agriculture, electricity, among others; administrative reforms (bureaucracy, judiciary); and privatisation of PSUs.

Market performance

 

"We would note that the market seems to be discounting the first scenario with most stocks trading at full-to-rich multiples and many ‘narrative’ stocks and PSUs trading at unfathomable multiples," the KIE note said.

On the other hand, BJP at 250+/- seats and NDA at 300+/- seats would 'significantly disappoint' the markets with a possibility of a meaningful correction in many of the 'narrative' stocks in the investment sector (capital goods, defense, electricity, EMS, railways, renewables) and PSUs.

That said, the major Indian stock market indices are likely to hold up reasonably well (a moderate correction, at worst), as the market will likely understand eventually that not much will change for several sectors such as banks, consumers, IT services, pharmaceuticals, etc. These sectors, the KIE note said, have a high weight in the usual market (Nifty-50, MSCI India) indices.

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Disclosure: Entities controlled by the Kotak family have a significant holding in Business Standard Pvt Ltd