India and the United States have the most expensive stock markets today. This should be concerning for investors because, during any period, an asset’s valuation at the start of a period is the most crucial determinant of its performance. The higher the valuation, the lower the returns; the lower the valuation, the higher the returns. Accordingly, Indian and US stocks have the least prospective returns, while European and Chinese stocks, due to their much lower valuations, appear to have much higher prospective returns.
However, these prospective returns don’t need to materialise in the future strictly. Low-valued assets with high prospective returns can continue to stagnate. Similarly, highly valued assets could rise further and become even more highly valued in the future, despite their currently low prospective returns. Valuation may be a crucial determinant of future returns, but it is not the only one.
In our previous market outlook, we postulated that a positive real interest rate of less than 1.5% is favourable for markets. India and the US, with real interest rates exceeding 2.0%, currently face highly unfavourable market prospects. Moreover, the high valuations in these markets have exacerbated their prospects.
European, Chinese, and Japanese stocks have a more reasonable valuation. However, among them, only European and Japanese economies have a favourable real interest rate. In China, although absolute interest rates have decreased in recent years and are now lower, the economy is in a deflationary phase. Stagnant consumer prices and declining producer prices characterise the Chinese economy of today, resulting in a higher real interest rate.
Meanwhile, the lower valuation and favourable real interest rates have worked out well for European stocks, which are the best-performing stocks so far this year. Also, they have the most favourable prospects today due to their reasonable valuation and the faster and larger decline in interest rates over the past year and a half. The prospects for UK stocks also look good. UK stocks are currently cheap, and the Bank of England has cut interest rates and indicated further cuts in its latest meeting.
The US economy has led the global economic growth since the COVID-19 pandemic. Following the COVID-19 pandemic, US stocks remained the best-performing asset among major asset classes until February 2025. However, despite the outperformance, many were sceptical about US stocks’ superior performance because only a select few large-sized technology stocks, nicknamed the Magnificent Seven (Alphabet, Meta, Microsoft, Apple, Amazon, Nvidia, and Tesla), contributed towards most of the gains. Worryingly, the market’s recovery from the (March, April) correction suggests that the already narrow market breadth has further narrowed.
After peaking on February 19, 2025, U.S. stocks endured a severe correction, coinciding with Trump’s reciprocal tariffs on April 2. However, US stocks have strongly recovered from the fall and today trade at fresh all-time highs. However, among the Magnificent Seven, only three stocks – Microsoft, Nvidia, and Meta – have fully recovered from the fall and have made new all-time highs. The other four stocks still trade below their February 19 highs, indicating that market breadth has further narrowed; the Magnificent Seven has now become the Magnificent Three.
Although the US economy has led the global growth over the past five years, the more we assess the underlying drivers of that growth, the more it seems precarious. They say that it was “American exceptionalism” that drove US economic growth. However, the truth is that the entire growth was fuelled by a massive load of debt, taking US debt levels to hazardous levels; US public debt as a percentage of GDP increased from 80 per cent in 2019 to 120 per cent today.
A debt-fuelled expansion is unsustainable, and the present one is very near to peaking; it may already have peaked. Once it peaks, the US economy will start deleveraging. Consumers, businesses, and government will enter a period of austerity, which could significantly slow down economic growth.
However, apart from austerity, there is another way governments can reduce their high debt burden. It is to inflate the debt away. They implicitly prefer this way over austerity. By allowing inflation to stay above the interest rates on these debts, governments can reduce their debt burden without any actual repayment taking place. Negative real interest rates – inflation exceeding interest rates – are preferable for governments with a high debt burden. However, an independent central bank, whose mandate is price stability, would then endeavour to correct the discrepancy of negative interest rates by resorting to interest rate hikes until inflation is anchored. The government will need to counteract such a hawkish monetary policy by making its fiscal policy even more expansionary and inflationary if it wants to inflate its debt away.
It could end well for both parties: central banks could have price stability, and at the same time, the government could inflate away a significant portion of its debt. However, a hostile relationship between the government and central banks will characterise these periods. Anyway, as each party strives to achieve its objectives by continuously counteracting each other’s moves, we would enter a period of high inflation and rising interest rates.
Capital always moves to places where it can get better returns. Between the early 1980s and the early 2020s (approximately 40 years), the US and other major advanced countries experienced a period of generally low inflation and declining interest rates. As interest rates reached low levels in the 2000s in advanced economies, capital began to move from these economies to developing and emerging economies, which offered higher yields relative to advanced economies.
These flows have created a stock market boom in many of these emerging markets, including India, where stocks have returned an average annualised return of 20% since 2003. However, as interest rates in advanced countries continue to rise, as anticipated, the capital flow towards developing and emerging economies from advanced economies in search of better yields will gradually slow down and soon reverse at some point.
Foreign capital flow was a crucial pillar of the Indian stock market boom that lasted for two decades, beginning in 2003. To keep our domestic financial assets competitive relative to foreign assets and arrest significant capital flight from our country, we must maintain a sufficient interest rate and prospective return differential between domestic and foreign assets. For that, stock prices should decrease to increase their prospective returns, and interest rates should rise so that yields on domestic fixed-income assets remain competitive in global markets.
Stock prices are highly correlated with corporate earnings. But it is not a 100 per cent correlation; maybe, there is a 60 per cent correlation. Similarly, the correlation between stock prices and economic growth might be less than 20 per cent. I believe that investor psychology and interest rates have a much higher correlation with stock prices than corporate earnings or economic growth. Interest rates and stock prices have a negative correlation: as interest rates rise, stock prices tend to decline; conversely, as interest rates decline, stock prices tend to increase.
However, the stock’s correlation with investor psychology is more complicated. Anticipating investor psychology is the most challenging task in investing. Investor psychology oscillates between optimism and pessimism, depending on investors’ perceptions of prevailing market conditions and future market prospects. This oscillation causes them to pay different prices for the same unit of earnings at various times. When optimistic, they pay a higher price for a single unit of earnings. Meanwhile, when pessimistic, they pay a much lower price for the same unit of earnings. The amount that investors will pay in the future for a single unit of earnings has a significant influence on our investment performance. It would surely be widely different from what they pay today.
Changing investor expectations about market prospects (market expectations) causes investor psychology to fluctuate. Stocks that are rising rapidly despite their elevated valuation are due to investors’ high expectations about the respective stock’s future earnings. But what shapes investor expectations? How accurate are investors in forming market expectancies?
We may presume that experienced investors are better at forming more realistic market expectations. However, the cumulative market expectations of all market participants—the consensus market expectation—that ultimately drive market prices are more likely to be erroneous. Apart from inexperience, there are more than one cause for the consensus market expectancies to be faulty. Investors’ overconfidence in their ability to forecast the future is one of them. Investors’ proclivity to adopt the prevailing general perception of market prospects, thereby bypassing the need for independent thinking, is another cause. Investors typically choose to be wrong together rather than be right alone.
Successful investing is not about having the most realistic market expectations and attempting to profit from them. Instead, it is about accepting that humans are fallible, causing them to form erroneous market expectations, and then trying to take advantage of the distorted market prices resulting from those erroneous expectations. But how do we know that the consensus market expectations are erroneous?
There are no rules or methods that could help you with that. Each new piece of information refines your understanding of markets and their prospects. In the process, at some time, one of those information ignites an insight or intuition that informs you that things are not as they appear to be. Further exploration will enable you to construct a variant market expectancy, which significantly deviates from the consensus market expectancy. It is time to sell stocks if the consensus market expectancy is much higher than your variant market expectancy; likewise, it is time to buy stocks if your variant market expectancy is much higher than the consensus market expectancy.
It is arrogant to assume that our variant market expectancy is accurate. A good investor must be humble enough to subject their market expectations to continuous refinement and adjustment.
Market expectations are formed from a market narrative constructed from available information. These narratives don’t have to be fully rooted in reality because information that disrupts the coherence of a narrative is conveniently sidelined or completely ignored. Humans understand events and situations through narratives, not through scattered pieces of vast information. Any piece of information alone is meaningless. Only narratives constructed out of information are meaningful and actionable.
Market participants often ignore any new piece of information that contradicts the prevailing narrative. New pieces of information will cause market participants to change their minds and, thus, their market expectations, only if they can aid in constructing a new narrative. Moreover, investors gradually adopt a new narrative, and then, out of necessity, they suddenly shift to it.
Currently, India has one of the most expensive stock markets in the world. This implies that Indian stocks are likely to deliver lower returns in the future due to an inverse correlation between stock valuation and prospective returns. However, Indian stocks have been relatively expensive for most of the last decade, which hasn’t, in any way, hampered their investment performance during the period; the Nifty50 has delivered an annualised return of 11% over the past decade.
India’s high economic growth could be attributed to the better market performance, despite the high valuation. However, the Indian economy’s growth prospects are severely dampened by the recently introduced 50% tariff on Indian imports to the US. However, that doesn’t necessarily mean poor return prospects. Historically, the correlation between stock returns and GDP growth has been weak.
Stock returns are most correlated with monetary policy (policy interest rates). Studies on the correlation between stock prices and policy interest rates find a 90% correlation between them. Hence, evaluating market valuation in conjunction with monetary policy action could provide a clearer picture of future stock returns.
Policy interest rates declined from 6.5% to 4.0% during the first five years of the past decade, then remained unchanged at 4.0% for the next two years, before climbing back to 6.5% over the next three years. Over the past eight months, rates have decreased by 50 basis points to 6.00%.
Economic growth and inflation are the two principal factors that determine the RBI’s monetary policy decisions. The adverse impact of US tariffs on India’s economic growth, combined with the prevailing lower inflation, suggests that policy rates in India are more likely to decline going forward. If so, conditions remain favourable for Indian stocks.
However, today, unlike in the past, there are strong constraints on how far policy interest rates in India could decline. Earlier, when policy rates in India fell from 6.5% to 4.0%, policy interest rates in the US and other advanced economies were near zero or less than one. Then, there was a robust, positive interest rate differential between India and other advanced economies. Today, the conditions are devoid of any such benefits. Policy interest rates in advanced economies are much higher today: 2.15% in the EU, 4.0% in the UK, and 4.50% in the US.
When the interest rate differential between India and the US narrows, Indian bonds become less attractive and US treasuries more appealing from a return-risk perspective. This could cause a capital outflow from Indian bonds to US treasuries as capital always moves towards places where the return-risk prospects are more favourable. Consequently, Indian bond yields rise as capital leaves India for the US until an equilibrium interest rate differential is achieved.
As Indian bond yields rise, Indian bonds become more attractive relative to Indian stocks, triggering a capital flow from Indian stocks to Indian bonds, which causes stock prices to decline. An interest rate differential of at least 2% should exist between Indian bond yields and yields in the US, UK, and the Euro. Presently, we have such a differential with the UK and the Euro, but with the US, it is tight at 1.5%. The impact on inflation from the recently introduced high tariffs on imports to the US has caused the Federal Reserve to wait for more clarity before considering a rate cut. That has kept US rates high. Indian stock prospects remain uncertain and limited until the US policy rates come down, bringing about a more favourable interest rate differential between India and the US.
The performance of the Indian rupee and the US dollar so far this year shows the precariousness of market and economic prospects in these countries. The rupee has declined against the US dollar this year. However, the severity of the decline has been masked by the decline in the US dollar itself, which had its worst first-half performance in 50 years this year.
Market participants use stock performance, inflation, and GDP growth to assess the health of the market and economy. These figures in India and the US have been promising lately. The narratives of the ‘Indian growth story’ and ‘American exceptionalism’ contributed to the superior market and economic performance in India and the US, respectively, in recent decades. However, these narratives might be faltering. The promising signs evident on the surface might be hiding risks that have accumulated underneath. Importantly, investors are unaware of the receding relevance of the narratives that have driven their decisions for decades.
Investors have shied away from active investing and flocked to passive investing over the past two decades – a trend prevalent globally. In the US, the trend has led to a decline in the share of active management in total US mutual fund assets, from 90% twenty-five years ago to 50% today. The primary reason for the trend is the dismal record of active funds in outperforming market indices. Most actively managed funds still fail to outperform the market indices consistently.
Meanwhile, passive investment vehicles, primarily index mutual funds and exchange-traded funds, have consistently delivered strong returns for investors over the past two decades or more. However, the concentrated flow of funds to passive funds may have engendered a bubble in index-constituting stocks. Large-sized, index-constituting stocks may have strong fundamentals and good growth prospects, but the share of their valuation representing these factors is less than 60% today. Research shows that, for US large stocks, the share of factors outside of a stock’s fundamentals in its valuation is close to levels seen during the late 90’s internet bubble.
The situation isn’t much different in India either. Valuation has run far ahead of fundamentals for most Indian large-cap and mid-cap stocks. Prices for these stocks increased by an average of 20% annually, while their earnings grew by 10% over the past two decades. From now on, even if earnings grow at 15%, stocks may deliver a return of less than 8%, due to moderating valuations. This means major market indices and funds tracking them will significantly underperform, at least, for the next decade.
Domestic fund flows from retail investors were a significant factor contributing to the current elevated valuation of Indian stocks. More than 50% of the assets under management of Indian mutual funds were raised in the last five years. Domestic fund flows provided a backstop against the sharp sell-off and exit by foreign investors during the past year. The strong fund inflow continues unabated to date. The fund houses are unlikely to discourage the sharp inflow of retail money, despite a lack of opportunities or high valuations, as their fees depend on the size of the fund, rather than its performance.
Low interest rates that prevailed globally after the global financial crisis of 2008 were another of the ‘other factors’ that drove and held stock prices higher. However, that supportive factor came to an end in 2022, following the steep interest rate hikes made by leading global central banks between 2022 and 2023 to combat high inflation in their respective countries.
However, it isn’t hopeless for investors. Investors can position themselves more effectively by focusing on stocks with a market capitalisation of less than ₹10,000 crores. Indian mutual funds have around 97% of their fund corpus invested in stocks with a market capitalisation greater than ₹10,000 crores. There are approximately 550 such stocks today, which account for only 14% of the nearly 4,000 actively traded stocks on Indian bourses. In other words, 86% of the stocks listed on Indian bourses remain vastly unexplored.
Valuation will be attractive for these unexplored stocks. But most might be of poor quality. Filtering out the good ones requires skill and effort; passive investing never required them. Active investing focused on underexplored, small-sized stocks is likely to deliver outstanding results for the next decade.
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