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The secret of the stock market rally

This report is from this week’s CNBC ‘Inside India’ newsletter, bringing you timely and insightful news and market commentary on the emerging powerhouse and the big companies behind its meteoric rise. Like what you see? You can subscribe here.

The big story

A man counts Indian rupee banknotes for a photograph near the Bombay Stock Exchange (BSE) building in Mumbai, India.

Dhiraj Singh | Bloomberg | Getty Images

Setting aside some of your income for a rainy day would generally be considered prudent behavior. Yet in India, this contributes to overvaluing stocks.

Systematic Investment Plans (SIPs) were introduced to help investors periodically set aside money in a disciplined manner. SIPs deduct cash from an investor’s bank account every month and invest the proceeds in selected mutual funds.

Strong and persistent marketing of the scheme over the past decade meant that 90% of all contributions to domestic equity mutual funds last year were made through SIPs. Contributions also hit a record high of 204 billion Indian rupees ($2.5 billion) in April, according to data from the Association of Mutual Funds of India.

While the benefits of the program are obvious, from reducing investment friction to removing the need for market timing, SIPs have also been partly responsible for pushing Indian stock markets to record valuations since they require fund managers to buy shares regularly.

For example, while the portfolio managers of India’s three largest multi-billion equity funds, SBI Equity Hybrid Fund Regular Growth, HDFC Mid-Cap Opportunities Fund-Growth and ICICI Prudential Balanced Advantage Fund, have ‘sufficient headroom to hold incoming deposits. temporarily in cash, their hands are often tied by their mandate to keep the funds fully invested.

As more money flows into these funds each month, portfolio managers are forced to buy stocks even when their valuations may not be as attractive.

“This particular product, and generally speaking, the domestic investor, has driven Indian stock markets higher,” Mahesh Nandurkar, head of India research at Jefferies, told CNBC. “If money goes into the funds, obviously the fund managers have to invest.”

He added that in addition to rapid growth in the underlying economy and corporate profits, SIPs had “certainly driven up valuations”.

High valuations have forced value funds such as Federated Hermes’ $3.1 billion Asia ex-Japan fund or Schroders’ Emerging Markets Value fund to pull out of the Indian stock market. Jonathan Pines, who runs the Federated Hermes fund, has previously said Indian mid-market stocks are in a “bubble” despite the country’s promising economic outlook.

For example, of the nearly 4,900 actively traded India-listed stocks, 300 stocks have seen their earnings decline over the last two consecutive financial years. Yet 216 of those stocks rose over the past 12 months, according to CNBC’s FactSet data tally.

In fact, small-cap companies such as the food packaging carton maker Rolling carts And Tantia Constructions, an infrastructure company focused on railways, bridges, roads and airports, has experienced three years of declining growth. Yet their stock is up more than 300% in the last 12 months.

That said, the positive impact of SIPs appears to outweigh the negatives for now.

Foreign investors have historically exerted significant influence on local stock markets. The largest stock indices, the Nifty 50 And Sensexsuffered declines and outflows when financial conditions tightened abroad, even though the companies that make up the index and the Indian economy have been largely isolated.

As the domestic investor base continues to grow, turbulence in foreign markets will likely have a more negligible impact in the future.

Deepak Jasani, head of retail research at HDFC Securities, said fund flows from 87 million investors investing around $32 every month “help reduce volatility caused by outflows (from portfolio investments foreigners) and contribute to increasing valuations when FPI flows are positive or neutral.

There is more to come. For now, savings directed to stock markets still represent only a tiny proportion of the overall savings that Indians put aside each year.

According to Jefferies, Indians save around 18% of GDP, or around $800 billion per year. Of this, only $40 billion – or 5% – is expected to be invested in stocks through SIPs, insurance and pension schemes.

As investors become more comfortable investing in the stock market, the proportion of savings and an increase in the total amount saved will likely send more money to this asset class.

“Although India is a low-income country, it remains a very high savings economy,” added Nandurkar of Jefferies.

Must know

India’s central bank approves highest dividend ever paid to government. The liquidity injection of 2.11 trillion rupees, announced on Wednesday, was significantly higher than analysts and the government’s forecasts. This will alleviate New Delhi’s need to borrow funds from the market and help it manage social and investment spending.

Volkswagen is in talks to establish a “partnership” on passenger car production. The German automaker already operates two factories in India. The group’s statements partly reflect concerns about the risk of an escalation in the trade war between Washington and Beijing and its possible implications for European automakers, most of which rely heavily on the Chinese market.

Modi’s strongman rule raises questions about India’s ‘democratic decline’. India’s economic growth has been robust and its geopolitical position in the world has improved during Prime Minister Narendra Modi’s first two terms. But the country has also witnessed signs of democratic backsliding that have become evident under his leadership, observers and critics say. The Sweden-based V-Dem Institute said a third term for Modi could worsen the political situation due to “continued repression of the rights of minorities and civil society.”

Bank of America ranks 3 Indian stocks among the “most important” in Asia. (Subscriber content) An industrial giant, one of the largest private banks and an IT company were on the Wall Street bank’s list. Backtesting shows the investment bank’s list of top stocks “reportedly outperformed in 16 of the last 29 calendar years.”

What happened in the markets?

Indian stocks are still up more than 2% this week. The Nifty 50 also rose around 2% last week and the index is up 5.7% this year.

The benchmark 10-year Indian government bond yield fell below 7% for the first time this year. Bond markets now expect India’s deficit to be lower than previously priced in due to the record central bank dividend described above.

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What’s happening next week?

India’s elections enter their seventh and final phase of voting next week. The results are expected to be announced after counting begins on June 4.

Data-wise, it will likely be a quiet week with US markets closed on Monday May 27. Shares of Awfis, the coworking and office space provider, will debut on Thursday.

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