India's Stocks Defy Gravity as Domestic Liquidity Fuels Rich Valuations

India’s stock market is riding high on a wave of domestic liquidity, defying global trends and maintaining lofty valuations that have left many analysts scratching their heads.

The MSCI India index is currently trading at a price-to-earnings ratio of 21 times two-year forward earnings, a stark contrast to the 10 times for emerging markets and 14.5 times for global markets. This represents a 100% premium over emerging markets, more than double the average premium seen in the 2010-2020 period.

While India’s growth story remains compelling, it no longer fully justifies the valuation gap, Macquarie analyst Aditya Suresh says. “While India offers a long growth runway over the past few years, consensus has accelerated this potential in earnings estimates,” he wrote in a note. “Even so, India’s earnings growth premium has compressed to effectively zero, against a typical 500bps premium, and we see expectations fatigue across sectors.”

The country’s return on equity has improved from 12% to 16%, driven by better margins and leverage, but this too falls short of explaining the current multiples. The real driver, according to Macquarie, is a flood of domestic liquidity. As India’s savings become increasingly financialized and the economy formalizes, local investors are pouring money into equities at an unprecedented rate. Mutual funds are seeing inflows of $3.1 billion per month in 2024, up from $1.7 billion in 2022-23.

This domestic wall of money has more than offset the tepid foreign inflows. In fact, foreign portfolio investors’ shareholding in NSE-listed companies has dipped below 18% of total market capitalization, the lowest since 2012.

The report sees a potential long runway for this trend. If the financialization of savings increases by just 500 basis points over the next five years, from 50% to 55%, Macquarie estimates it could lead to a 3.5 to 4-fold increase in equity market flows.

This liquidity-driven market is not without risks, to be sure. The report flags potential earnings fatigue, a sharp compression in growth premium, and insider selling as key concerns. Indeed, there are signs that promoters and private equity investors are taking advantage of high valuations to cash out.

For global investors, the message is clear: India’s market dynamics are increasingly driven by domestic factors, creating a disconnect with global trends. As the country’s economic weight grows, understanding these local liquidity flows becomes crucial for anyone looking to navigate the world’s fifth-largest stock market.

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