“The concept of mean reversion is the most powerful tool in the investor’s toolkit.” – Jeremy Grantham
NIFTY 50, Midcap, and Small Cap Indices: Analysing Overvaluation Risks and Market Trends
The recent performance of the Indian stock market has been marked by challenges. Many analysts attribute this weakness to high valuations amidst clear indications of slowing economic growth. It is important to note that high valuations alone are seldom the sole cause of a market correction. Typically, multiple factors converge to give the market a rationale for its movements. Some segments of the market have indeed exhibited high valuations, a condition that has persisted for some time. Additionally, factors such as the weakening rupee, tighter monetary and fiscal policies, trade wars, and geopolitical tensions have likely contributed to the market’s decline.
Snapshot of valuation of Indian indices
I analyzed trailing valuations using PE ratio, PB ratio, and dividend yield. Higher PE and PB ratios indicate a more expensive market, while a higher dividend yield suggests better value. I also examined the average and percentile rank of current values. The key conclusions are:
- Large cap indices are near their long-term average valuation.
- Midcaps are the most expensive. Small caps also are richly valued
- Indices near average valuations should perform better than those at peak valuations.
- From a mean-reversion perspective, indices trading near their average valuation are more likely to generate returns that align with their future earnings growth. Conversely, indices with elevated valuations may produce returns below their earnings growth as their valuations gradually revert to long-term averages.
- Indices with high valuations have limited capacity to withstand any earnings disappointments or adverse events, such as management changes or the cancellation of significant orders. This is evident in the ongoing earnings season, where stocks with earnings slightly below expectations are experiencing notable corrections.
A look at the recent performance of the market
CAGR represents annualized returns over a specified period. The 10Y CAGR shows the latest annualized return for the last 10 years, with its average indicating long-term value. Key insights from the table:
- Over the long term, mid and small caps do not always yield higher returns (see 10-year CAGR average).
- Large caps have underperformed in the past decade, while small and mid-caps have exceeded historical averages.
- This suggests large caps have less downside risk compared to small caps.
- During severe market corrections, small and mid-caps experience larger drawdowns.
Disclaimer: The above content is just for information and should not be construed as an offer to buy or sell or recommendation. Contact your financial advisor for guidance on any investment related query.
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