Indian Stocks' Near-Term Caution Bodes Well For Bulls Eyeing Buy-On-Dips

The near-term caution on India's $5.52 trillion stock market will serve as good news for investors waiting on the sidelines given the pricey valuations.

India's benchmark indices —NSE Nifty 50 and BSE Sensex— have outperformed the global market this year and rank as the fourth and sixth best-performers in Asia, respectively.

However, the possibility of a near-term correction is eminent given the headwinds, according to analysts.

There are many sources of correction for this strong bull market, both fundamental and technical, Ridham Desai, equity strategist at Morgan Stanley, said in a note earlier.

"A correction will test money in the market and possibly excite money on the sidelines," Desai said.

A potential growth slowdown for the first time since Covid-19 and the state-level spending splurge are the two fundamental risks to the ongoing bull run. The possibility of retail money shifts to the primary market and a sharp sell-off outside India, especially in the US, could be two technical risks to monitor, according to Desai.

Expected tax hikes on equity capital gains, a possible slowdown in government capex and potential policy hikes might weigh on the ongoing rally, according to Jefferies. "Notwithstanding our optimistic view from long-term perspective, we are cautious on the markets near-term."

Additionally, a lower-than-anticipated cut in interest rate by the US Federal Reserve in September will have markets on edge, according to Andrew Holland, chief executive officer of Avendus Capital Pvt.

Any steep correction in equities globally would not replicate in India as the domestic market had become a low beta market with high cash levels, he said earlier. However, he said, "I don't think markets can go much higher in the short term."

All this combined with the pricey valuations the domestic stocks are quoting at, will weigh on the benchmarks in the short term.

The mid-cap benchmark is valued over Nifty 50 and the small-cap stocks continue to gain more despite froth concerns. The price-to-earnings ratio of the Nifty is valued at 24.4, while that of the small-cap and the mid-cap index is at 33.6 and 45.8, respectively.

While the market is poised for a temporary correction, India's bull run is only past the halfway mark, Desai said.

India's stocks "continue to climb the wall of worry, leaving many professional investors perplexed," Desai said, but added that the bull market is still not at its peak as the expected confluence of excess leverage, profits, prices, valuations and sentiment is still not seen yet.

The next leg of the bull market is expected to come from earnings growth fueled by private borrowing and spending, Morgan Stanley said. "We see a structural rise in equity holdings on household balance sheets being supplemented by higher global allocations to Indian stocks reflecting India’s rising index weight."

The Indian market has taken a breather after being on a record run in early August. The NSE Nifty 50 and the 30-stock Sensex have risen 16.8% and 14.8%, respectively, so far this year.

India's macro story remains strong and the growth uptick was led by a capex cycle which has headroom to expand, Jefferies said.

Domestic inflows that have been powering India's stock market may see a short-term pause after having pumped up valuations, it said. However, the brokerage expects foreign flows to provide a cushion to domestic flows that may take a breather.

Foreign inflows into India during the previous rate cuts have historically been negative in the short term in most instances. But India remains better placed compared to its peers in the overall emerging markets this time, Citi said in its latest report.

In the case of Fed rate cuts, while Citi's global peers believe India remains relatively better placed versus overall EMs, they nonetheless believe that the set-up is trickier for emerging market equities in general.