Economic Survey 2024-25 has a word of caution for equity market investors. The survey highlights a strong correlation between the US and Indian stock markets, with India’s Nifty 50 often reacting to US market movements. It cautions investors about elevated US valuations and the potential for a correction in 2025, which could significantly impact Indian equities, especially given the rise of new retail investors.
The US equity markets had a solid run for the second year in a row, outperforming the broader developed market pack.
Following a 24 per cent gain in 2023, the S&P 500 Index generated a 20 per cent plus return in 2024. This outperformance came on the back of economic resilience, robust corporate earnings that have surged to record-high levels (~USD 4 trillion as of the quarter ending September 2024), strengthening rate cut expectations early in the year and all-time high investor confidence.
That said, the surge in US stock market valuations, currently at their third highest levels as indicated by Robert Shiller’s S&P 500 CAPE ratio (Cyclically Adjusted Price-Earnings Ratio), warrants some caution.
Further, the rally over the last two years has been largely driven by a few mega-capitalisation technology companies—Apple, Microsoft, Amazon, Alphabet, and Nvidia.
This is reflected in a strong 40 per cent+ year-to-date return in the S&P 500 Top 10 Index.
The performance of the S&P 500 Equal Weight Index, which assigns equal weight to all 500 constituents, effectively diluting the impact of the largest companies, is also a good assessment of the performance of the S&P 500 excluding these companies.
The S&P 500 Index has rallied by a total of 56 per cent in 2023 and 2024, more than double that generated by the equal weight index.
This, along with tapering rate cut expectations, with the US Federal Reserve’s dot plot now suggesting a 50bps cut in 2025, down from the earlier guidance of 100bps, has added to the potential risks and uncertainties.
History shows sentiment-driven rallies are often fragile, with confidence shifting rapidly in response to external shocks, such as geopolitical events, policy changes, or economic slowdowns. This makes the current environment particularly susceptible to volatility, with any unexpected developments potentially triggering significant market corrections.
At the same time, questions are emerging about the sustainability of U.S. corporate earnings, particularly as they are concentrated within a few major technology firms and supported by strong government spending, up 10 per cent YoY to USD 6.75 trillion from October 2023 to September 2024.
What does the history tell us?
Historical data and research suggest that the Indian equity market has been notably sensitive to movements in the US market.
The Nifty 50 has historically shown a strong correlation with the S&P 500, with analysis of daily index returns between 2000 to 2024 revealing that in 22 instances when the S&P 500 corrected by more than 10 per cent, the Nifty 50 posted a negative return in all but one case, averaging a 10.7 per cent decline.
On the other hand, during 51 instances when the Nifty 50 experienced a correction of over 10 per cent, the S&P 500 exhibited positive returns in 13 instances, averaging a 5.5 per cent decline.
This underscores the asymmetric relationship between the two markets, highlighting a more pronounced impact of the movement in US markets on Indian equities than the other way around.
Further evidence shows that changes in the US market are a leading indicator for the Indian market, especially during shocks, while the reverse is not true.
This emphasizes that Indian markets tend to react more to trends originating in the US, reinforcing the need for caution in the event of a downturn in the latter’s stock market.
Potential risks for India in 2025
Elevated valuations and optimistic market sentiments in the US raise the likelihood of a meaningful market correction in 2025. Should such a correction occur, it could have a cascading effect on India, especially given the increased participation of young, relatively new retail investors.
Many of these investors that have entered the market post-pandemic have never witnessed a significant and prolonged market correction. Hence, if one were to occur, its impact on sentiment and spending may be non-trivial.
