Double whammy! High valuations, dull Q2 earnings make Indian stock markets volatile. How to trade now?

The Indian market, with its high valuations, appears to be grappling with consecutive challenges in the eventful months of September and October. Against the backdrop of lacklustre Q2FY25 earnings, significant selling by foreign portfolio investors (FPIs), ongoing geopolitical tensions, a strong dollar, consecutive Chinese stimulus announcements, and the impending US election, the market seems to be tilting towards volatility, causing concern among investors about what might happen next.

Amid heightened volatility, the Nifty 50 has already seen a 5% decline in October so far, reflecting the prevailing bearish sentiment in the domestic market.

Mohit Gulati, the CIO and managing partner of ITI Growth Opportunities Fund highlighted that Indian stocks are currently trading at high valuations, with the Nifty 50 at around 20-21 times forward earnings, a notable premium. Recent Q2 earnings on expected lines have fallen short, leading to forecast downgrades and raising concerns about a potential 5-10% valuation correction as earnings adjust.

In its recent report, Kotak Institutional Equities expressed concerns about the poor performance of 2QFY25 earnings season, indicating subdued trends across various sectors. The brokerage remains concerned about possible risks to profitability and volumes across various sectors because of disruptions and companies' emphasis on profitability.

Additionally, foreign portfolio investors (FPIs) have pulled over $10 billion this October, the highest monthly outflow on record, influenced by rich valuations and geopolitical tensions. Analysts suggest that the strong domestic liquidity is currently working in favour of the Indian market.

“The high Indian market valuations have been sustained mainly by the robust domestic liquidity. However, rising market and falling earnings growth are not compatible which is why the market has been correcting triggered by the sustained Foreign Institutional Investors (FII) selling,” said Dr. V K Vijayakumar, Chief Investment Strategist, Geojit Financial Services.

The Nifty 50 is being impacted by a surge in bond yields. During Tuesday's trading session on October 22, all sectoral indices closed in the red, resulting in a 1.25% decline for the Nifty 50, which settled at 24,472.10.

Government bond yields reached their highest levels since mid-summer on Tuesday, following the surprising move in the bond market after the Federal Reserve's rate cut last month. In morning trading on Tuesday, the benchmark 10-year US. Treasury note saw yields rise above 4.2% for the first time since July 26, while the 2-year government bond yield reached its highest level since August 20 at 4.06%, according to CNBC data.

What should investors do?

Prioritize safety

Dr. V K Vijayakumar said that FY 25 earnings growth is likely to be about 10%. But in FY 26 earnings can pick up by about 15%. Nifty 50 may see strong buying support at around 24,000 level.

“Investors should give priority to safety now. Largecap financials look attractive for investment. IT and leading telecom and capital goods stocks also ate investable,” advised Vijayakumar.

Maintain a long-term perspective

Mohit Gulati believes that for FPI inflows to return, stabilizing valuations, improved earnings growth, heightened global risk appetite, and relative attractiveness of Indian equities are essential. FPIs are expected to remain volatile despite anticipated corrections, although domestic institutional buying supports the market.

"Investors are advised to maintain a long-term perspective, take advantage of market dips to buy quality stocks, focus on strong earnings, diversify their portfolios, and consider staggered investments via SIPs or STPs. In summary, while a valuation correction seems imminent, significant FPI inflows may not materialize immediately, underscoring the importance of focusing on fundamentals to navigate market volatility. Its in times like these that the Men get distinguished from the Boys. The fly-by-night market participants will feel the pinch the most,” explained Gulati.

Disclaimer: The views and recommendations above are those of individual analysts, experts and broking companies, not of Mint. We advise investors to check with certified experts before making any investment decision.