India's stock market is on a roll. But amid the frenzy, investors need to look ahead and be wary of share prices rising to unreasonable levels.

After the equity market reached the US$4 trillion valuation mark last December, investors poured another US$1 trillion into the capitalization of listed companies within the first half of 2024.

Behind the market’s skyrocketing gains is a host of upbeat data, including those on the country’s burgeoning economic growth and robust corporate performance.

The bullish sentiment fuelling the market momentum is expected to last for a while, yet there are concerns that investors are focusing too much on certain sectors and stocks, leading to overvaluation.

A recent survey by Deloitte and market intelligence portal Moneycontrol finds that more than half of chief executives interviewed believe the Indian stock market is overvalued.

As early as February, Kotak Mahindra Bank’s brokerage arm, Kotak Institutional Equities, warned that the market was overvalued by 20%. The feared correction didn’t transpire, however, and the country held a successful general election, which further lifted the buying mood.

Kotak issued another report in June, saying investors were overlooking risks in terms of corporate fundamentals. “The stocks could see massive correction (by as much as 50-75% in many cases) if and when the market was to take a more realistic view of the prospects of such companies,” says the report. “However, the current ‘euphoric’ state of affairs could continue for a while, resulting in a continued large disconnect between their market prices and fundamental fair values.”

An August reading of the Nifty 50 shows a price-to-earnings ratio (P/E) of 22.5x, surpassing the one-year and two-year average and near the three-month and six-month high. The current price-to-book ratio (P/B) is 4.1x, above the average for three months, six months, one year, and five years. All this indicates that stock prices are unreasonably expensive compared to their intrinsic value.

Broken down by sectors, technology is trading up by more than 10% year-to-date, with the Nifty IT’s P/E hovering above the 30x level and the P/B at 8.1x, almost twice that of the Nifty 50’s.

Tech sector faces headwinds

Nonetheless, strong fundamentals seem to underpin the investment frenzy over tech stocks. The tech sector, with a market size of US$254 billion and a workforce of 5.4 million, contributed a hefty 7.5% share to the country's gross domestic product in fiscal 2023, according to the National Association of Software and Services Companies (Nasscom).

However, while the IT sector is currently a major factor in the country’s exponential economic growth, its expansion is bound to wane in the near future.

The sector’s growth was estimated to have halved to 3.8% in fiscal 2024 from 8.4% in the previous year, amid weakening software exports and sales of products and services. The tech job market probably shrunk by 80% during the period. Fitch Ratings says fiscal 2025 will continue to see modest growth as clients’ discretionary spending on IT remains stalled while costs rise.

Government incentives have spurred the rise of start-ups in recent years. A well-structured ecosystem incubated more than 5,500 active tech start-ups between 2014 and 2023, of which 950 were added in 2023 alone.

However, some of the start-up business models have proved hard to sustain. For instance, WeTrade, a crypto trading platform, closed shop only half a year after it launched as funding dried up and the business environment turned “hostile”.

Edtech platform Byju’s was once the country’s most valuable start-up, worth US$22 billion. However, its fortunes took a turn for the worse in 2023 after it was implicated in legal disputes and probed by the government’s Enforcement Directorate; it missed the deadline for financial reporting.

The incidents prompted key shareholders such as BlackRock, Prosus, and Baron Capital to slash the valuation of their stakes in the start-up. In a June research note, HSBC implied a zero value for Byju’s.

Despite the problems facing the sector, several tech start-ups are still actively working to launch initial public offerings, and some have set timelines for entering the equity market, whetting investor appetite all the more.

FMCG and healthcare soar

Overvaluation is also seen in other prominent industries, including the fast-moving consumer goods (FMCG) sector, whose P/B has reached 9.4x and P/E a startling 51.1x.

Analysts, however, have remained upbeat about the business. According to IIFL Securities, the FMCG sector has displayed stability that makes it a good hedge against market volatility, noting that the Nifty FMCG’s return has outperformed that of Nifty 50’s.

In fact, it says in a report that investors have flocked to the sector due to market uncertainties, which have intensified since the mid-2020s. “This indicates that a large part of the demand for FMCG stocks, which has driven up their prices, has come up from investors taking recourse to them in times of high economic uncertainty,” it says.

Although FMCG stock prices remain at high levels, the sector is likely to sustain its growth of as much as 9% for fiscal 2024, driven by surging rural demand and stable urban consumption, according to Crisil Ratings.

“For the first time in 2023, consumption gaps between urban and rural markets are narrowing down. The North and West regions are contributing to this phenomenon,” says Roosevelt Dsouza, head of customer success, Indiam at NielsenIQ in a report. “The favourable interim Union Budget 2024-25, supporting several economic boosters for the rural sector, should bode well for companies with a rural strategy.”

Healthcare is another sizzling sector, with its P/B standing at 6.4x and P/E at 41.6x. Hospital stocks are driving the rapid growth. Three of the largest are Apollo Hospitals Enterprise, Max Healthcare Institute, and Fortis Healthcare, which have surged 13% to 26% year-to-date. Another hot subsector is diagnostics, which Crisil Ratings forecasts to grow by as much as 11% in fiscal 2025.

Along with the rising demand for healthcare services, however, is the tightening of regulation for the sector. The Supreme Court, for example, has set a pricing benchmark for hospital charges, which will potentially impact the subsector’s profitability.

There is also the fact that the Indian stock market is facing excess liquidity, which implies that more capital will be spent on already pricey stocks such as healthcare stocks, further pushing up valuations.

The market frenzy has attracted retail investors, especially those who just follow the herd; their punts have been rising since last year. This bodes well for market development, as long as they stay nimble and prudent, especially when there are abrupt market movements.

“The significant increase in retail investors in the stock market calls for careful consideration,” the government warns in the Economic Survey 2023-2024. “This is crucial because the possibility of overconfidence leading to speculation and the expectation of even greater returns, which might not align with the real market conditions, is a serious concern.”