Valuations for Indian equities are looking eerily similar to 2007, a top brokerage said. BSE500 companies are trading at median trailing price to earnings multiples of 43x, nearly twice the median earnings growth and substantially higher than any time in the past. The market cap to GDP ratio is at a record. The valuation premiums of small and mid-caps to headline indices are at historical highs. Equity valuations relative to interest rates and the earnings yield minus bond yield gap are also flashing red (see table).

“Valuations are now extreme,” said a note put out by Nuvama Institutional Equities. “While companies boast of better cashflows today, the growth, RoE and capex was significantly better in 2007. Expect sub-par five-year returns of lower than 5 per cent CAGR with potential drawdowns à la 2000, 2007.”

Earnings growth has moderated and US recession risks are rising, which could hit investors’ appetite for equities, the brokerage said. And while domestic flows continue to remain strong, household exposure to equities stands at an all-time high even as income dynamics are weakening.

“Valuations across market capitalisations are above their long-term averages. One can see some amount of consolidation given that triggers such as the elections and Budget are already behind us,” said Ashish Gupta, CIO, Axis Mutual Fund.

Nuvama believes that while the quality of SMIDs may have improved, the premiums are highly unsustainable. “Cyclicals and mid-caps have rallied only in India and have been largely rangebound globally. Such decoupling is very unusual. While India does outperform EMs during bull phases, its melt up this time is quite unique,” it said.

“Over the past year, mid- and small-cap indices have outperformed the Nifty 50 by 24 per cent and 31 per cent, respectively, with some sectors particularly amongst industrials trading at a premium. Mean reversion is expected in these richly valued sectors,” added a note by Mirae Asset Investment Managers.

In the past, after a melt up, mid caps have had large phases of consolidation with drawdowns. Post the peak in 2018, mid-caps corrected by 30-40 per cent and were up only 20 per cent from their 2018 peak as of March 2023.

Sectoral bets

The brokerage believes that FMCG and telecom can be good bets in the current environment. “FMCG‘s relative performance is inversely linked to Nifty earnings and with the latter likely to underperform, there is a strong case for FMCG’s outperformance. Price hikes and peaking capex are likely to result in large cashflow generation for telecom companies.”

Axis MF’s Gupta is positive on consumption and believes that improving rural demand coupled with the government’s initiatives on upskilling the youth can boost demand in the longer run. “A good monsoon will add to better crops and lower inflation. The trend of premiumisation continues, benefiting various segments within consumer discretionary. Automobiles, real estate and high-end retail have all experienced growth. Separately, the housing sector is witnessing increased absorption across India, and with the government’s emphasis on affordable housing, real estate, building materials and related industries are poised to benefit,” he said.

Mirae Asset feels that diversified equity funds such as large-caps, flexi-caps and multi-caps are most suited in this environment. Hybrid funds, given their flexibility in asset allocation, can also be made part of the core portfolio.

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