India's equity market at risk of significant drawdowns, warns report

New Delhi [India], August 4 (ANI): The current market valuations in the country have reached levels reminiscent of the trends observed in 2007, according to a study by wealth management platform Nuvama.
The report claimed that elevated valuations could result in underwhelming five-year returns, projected to be less than 5 per cent of the Compound Annual Growth Rate (CAGR), accompanied by a heightened risk of significant drawdowns.
"At such high valuations, we can expect five-year returns to be underwhelming (< 5% CAGR) with a heightened risk of significant drawdowns. Additionally, slowing earnings growth and potential recession risks in the US labour market suggest we might be approaching an inflection point," it added.

Highlighting the situation, it further added, "Earnings downgrade cycle has begun as profit growth is converging with anaemic top-line growth."
This situation further points out that slowing earnings growth and potential recession risks in the US labour market suggest that the market might be approaching a critical inflexion point, the Nuvama reported.
As per the report, despite robust market flows complicating the identification of a peak, the focus remains on relative valuations as the primary guide.
The report highlights the key indicators which reflect the extreme valuations in the Indian markets. It added that the market cap to GDP ratio stands at 150 per cent, matching the 2007 peak.
The median trailing price-to-book (P/B) ratio of BSE500 companies has surged to six times with a 15 per cent return on equity (RoE), compared to the 2007 peak of 4 times with a 25 per cent RoE, it added.

Return on equity or ROE refers to a measurement of an enterprise's performance in a given period.
Additionally, the premium relative to emerging markets (EM) has doubled from 50 per cent in 2007 to 100 per cent now, it added.
Pointing out the worrisome trend, the report added, "Out of the 108 billion options contracts traded worldwide last year, 78 per cent were from Dalal Street, where retailers make up 35 per cent of derivative trading."
"The derivatives turnover on the NSE has surged 30 times from Rs 247.5 lakh crore in March 2020 to Rs 7,218 lakh crore in March 2024," it further highlighted.
After weeks of warning from SEBI, RBI and the FM, the market regulator released a 'consultation' paper proposing measures to reduce trading activity in options.
The report cited the market regulator SEBI, who said, "India's equity derivatives market is becoming a macro-economic concern and not just a micro issue of investor safety. Time to consider if household savings are going into speculation instead of capital formation."
As mentioned in the report, the market data reveals that the starting point of valuations explains 70-80 per cent of five-year returns, making it an invaluable guide during extreme market conditions. Markets often experience long phases of consolidation, lasting 5-15 years, with significant drawdowns following a high-valuation bull market. Notable examples include India (2007-2013), the US (2000-2012), and MSCI EM (2007-current).
The report also points out that improved free cashflows compared to 2007 partially offset lower RoE but it is still caucious.
"While improved free cashflows compared with 2007 partially offset lower RoE, we doubt "this time is different"," the report added.
However, on the domestic front, risk appetite remains strong, with household equity exposure at an all-time high, despite weakening income dynamics. Globally, rising recession risks in the US could dampen risk appetite, and potential rate cuts amid a recession offer little consolation, as per the report.
In light of these valuation concerns, the report suggests structuring portfolios based on valuations.
The Nuvama recommendations include being overweight (OW) on sectors with reasonable valuations such as private banks and insurance, defensive cash cows like FMCG and telecom, and sectors with high valuations but depressed earnings, including chemicals, IT, and durables.
On the other hand, the report advised to stay away from the sectors where valuations are high. Among the sectors where valuations have touched a peak are metals, autos, and public sector units (PSUs). (ANI)