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We live in complex times. We have long viewed stock markets as a barometer of economic health. They mirrored the possibility of future earnings, sentiment, liquidity, and investment. Akin to the “man in the mirror,” policymakers and investors could gauge the health of corporate earnings and future growth, and participate in a feedback loop of investing in companies with higher earnings potential.

Stock market assessment reflects the theoretical underpinning of Tobin’s seminal work, where he emphasized the importance of comparing market value with replacement cost of capital. In simple terms, firms invest when their market valuation exceeds the cost of replacing their assets.

A better way to assess the stock market in India, as in other bourses, is therefore not only by looking at the Nifty 50 level, but by examining the Nifty P/E (Price to earnings) ratio The P/E ratio is akin to Tobin’s valuation logic, as it reflects how much investors are willing to pay today for a unit of earnings, and therefore captures the market’s assessment of future growth and expectations.

The stock markets in India rallied. Equity markets have always been a coveted asset class in India because, from a tax perspective, there is a positive skew. During the falling interest rate regime around the COVID period, we saw an influx of retail participation.

Small investors made inroads into Indian bourses through the SIP (Systematic Investment Plan) route. By this period, share prices had risen significantly, and the Nifty had recovered sharply from its COVID lows and went on to reach record levels.

This led to the Nifty rebounding from around 7,500 during March 2020 and crossed 20,000 in in September 2023. The abundant liquidity created by a low interest rate regime saw investors taking on higher risk and flocking to the stock market.

But as Nifty prices rose, (and crossed 26000 in September 2024) earnings did not fully catch up. Share prices rising, partly driven by increased retail participation, did not always reflect commensurate growth in underlying earnings. Foreign institutional investors (FIIs), who have traditionally acted as a key anchor in Indian equity markets, began to observe a widening divergence between Nifty 50 levels and valuation multiples.

The Nifty P/E ratio rose to elevated levels, peaking around 38–42x during the post-COVID liquidity phase in 2021 - 2022, reflecting a period where prices were being supported more by optimism, liquidity, and flows than by earnings growth. As valuations expanded, concerns over stretched pricing began to emerge.

Consequently, FIIs, who had been strong net buyers during 2020–21, turned more cautious from around 2022 onwards, with more sustained periods of selling pressure and reduced participation by 2024, amid rising global interest rates and valuation concerns.

In a world of information asymmetry, traditionally FIIs make informed choices among different global markets. They are driven by fundamentals and are sensitive to global macroeconomic conditions. Hence, they are more responsive to the risk-return calculus, which begins to change due to rising interest rates abroad and tightening global liquidity.

Consequently, FIIs started selectively positioning and treading cautiously and beginning to exit from India. By 2025–26, net FII flows turned negative in certain phases, reflecting a more cautious and selective stance toward Indian equities.

The divergence between the Nifty 50 and the Nifty P/E ratio actually mirrors and explains why Indian stock markets have, at times, appeared less lucrative in recent phases. The “man in the mirror” in this context is not the index level itself, but the valuation multiple that investors are willing to assign to earnings.

While policymakers often focus on attracting foreign institutional investors and managing capital inflows, what ultimately needs attention is the quality and sustainability of earnings growth that justifies prevailing valuations. If valuations run ahead of earnings for extended periods, markets may deliver lower subsequent returns, not because capital has disappeared, but because expectations embedded in prices have already been exhausted.

The “man in the mirror” that needs to change is not capital flows or investor participation, but the level of valuations being justified by earnings growth.

Dr.Sarika Rachuri teaches in ICFAI business School. 

Badri Narayanan Gopalakrishnan is a senior economist and affiliate faculty member at the University of Washington Seattle.

 

(The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of New India Abroad.)

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