In a tight spot: Sustained stock market correction will test investors

India’s stock markets are experiencing increasingly bearish trends. While the benchmark Nifty fell 2.7 per cent last week, the broad NSE500, which tracks 500 largest stocks listed on the National Stock Exchange (NSE), dropped 4.7 per cent. The midcap and smallcap indices dropped 7.4 per cent and 9.6 per cent, respectively. The downtrend has been in force for a while. This broadly bearish sentiment is illustrated by the fact that only 47 stocks in the NSE500 advanced in the past week, while 452 stocks lost ground. From a longer perspective, the Nifty has returned a nominally positive 4.6 per cent in the last year. That is less than the yield from treasury bills, or the rate of inflation, for that matter. The NSE500 is up just 2.9 per cent and the midcaps have returned a meagre 2.5 per cent return in the same period, while the smallcaps are down 3.3 per cent. The Nifty smallcap 100 has fallen 21.6 per cent from its highs and is now in bear territory, while the midcap index has fallen over 18 per cent.

 

There are multiple data points contributing to the pessimism. Foreign portfolio investors (FPIs) have sold equity worth almost Rs 1 trillion since January 1. The rupee has lost ground against the dollar, testing Rs 87.99 before seeing a small recovery on the central bank’s intervention. The Q3FY25 results have been disappointing with slow growth in profits and revenue, and management guidance in most sectors has been cautious. Overall economic-growth estimates have been downgraded. Consumption-driven businesses have pointed at weak demand. The Union Budget may not provide much of a stimulus with a pullback on infrastructure spending likely to offset any potential stimulus from the income-tax cut. Investors who were fence-sitting until the Budget have gone bearish while FPIs have continued selling. The Reserve Bank of India’s decision to cut the policy rate and possible future cuts may not move the markets materially.

 

Export-oriented companies have also pointed to demand weakness in key markets, such as the European Union. There is also great uncertainty regarding the direction of the American economy, with the Donald Trump administration apparently set on imposing tariffs. One bright spot is that mutual funds continue to see large inflows, which indicates households are still backing equity. However, a large proportion of mutual-fund subscriptions come from systematic investment plans (SIPs), which are generally locked in for specific periods. For tax reasons, most SIPs tend to end in March — the April data will help in assessing if retail investors retain their bullishness. One negative signal when it comes to retail sentiment is the selloff in smallcaps; small stocks with little in the way of institutional interest are the focus of retail investors.

 

However, despite the recent correction, valuations look rich in the case of large stocks, and unsustainably high for smaller stocks. The Nifty is trading at a current price-to-earnings (PE) ratio of around 21, which is somewhat on the high side, going by historical valuations. The midcaps are trading at a PE of 28 while the smallcaps are doing so at 34. Corrections in the Nifty usually bottom out at around a PE of 15. Unless there’s significant acceleration in the rate of profit growth, further corrections appear to be on the cards. This may test the resolve of the retail investors, who have driven the market over the past five years.