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markets: Indian equities show some signs of overheating

ET Intelligence Group: Indicators ranging from valuation to technical parameters and relative stock performance to earnings yield suggest that India’s current degree of equity outperformance may not sustain in the near term.

Indian equities have outperformed the MSCI World index by 22% in the past one year, the most in seven years, show data from Bloomberg. They also outpaced the emerging market counterparts (MSCI EM index) by 36%.

A large part of the gain in the current calendar year has been driven by domestic money – Indian equities received just $1.5 billion of foreign inflows in the last six months despite foreign investors reducing their exposure to China.

Local equities delivered a return of about 12% in the third quarter of 2021 so far, one of the best among large markets. They have also not seen any correction of over 10% in the past 260 days, which is the third-longest rally ever after 2013 and then in 2016.

Historical data suggest that if Indian equities reach such a high level of outperformance, then the returns become muted for the next few months. According to Jefferies, a high degree of outperformance is usually followed by India underperforming by 11%, 6% and 7% on average in the following 90, 180 and 365 days, respectively.

equityBloomberg

The absolute and relative valuations of Indian equities are hovering at a record levels. The Nifty50 is trading at 22.3 times the one-year forward earnings, a 41% premium to its long-term average.

A comparison of PE of the top global equity indices shows Nifty’s valuation as the most stretched by a margin at nearly the 100th percentile of the 16-year trading range, show data compiled by CLSA. No other market is within 5% of the record valuation in terms of the percentile trading range.

On relative valuation, the price-earnings premium of India has reached a record level against Asian counterparts, while the premium with EM peers is at a more than 15-year high. The gap between the bond yield and earnings yield – an inverse of price-earnings – is 1.65, compared with the average of 0.97. A reading of a yield spread of more than 1.65 has historically resulted in negative returns in the following 12 months.

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