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The Indian equity markets have entered a phase of recalibration, with February 2025 marking another month of correction. Amid global economic shifts, foreign investor outflows, and moderating earnings growth, market sentiment remains fragile. While broader indices have seen substantial declines, select pockets of resilience offer glimpses of stability. The current downturn, though concerning, aligns with historical market cycles, suggesting potential recovery as valuations adjust. This report delves into the prevailing market conditions, the factors influencing investor sentiment, and how valuations across indices and sectors are evolving.

Note 1- Market Weakness Deepens as Indices Adjust to New Realities

Indices Extend Decline Amid Broader Market Weakness

The equity market continued its downward trajectory in February, registering the fifth consecutive month of correction. The Nifty-50 fell 5.9% MoM, while the broader Nifty-500 and Midcap 100 declined 7-10%. The underperformance of midcaps and smallcaps, which had led the market’s rally in 2024, has now resulted in a sharp valuation reset. Historically, such corrections take an average of 200 days to recover, suggesting that markets may still be in the latter stages of this downturn.

FII Selling Accelerates While DIIs Counterbalance

Foreign Institutional Investors (FIIs) continued to exit Indian equities, offloading $5.4 billion in February after a heavier $8.4 billion sell-off in January. This brings total FII outflows in CY25 YTD to $13.8 billion. The primary drivers behind this exodus are rising US bond yields, global economic concerns, and a shift toward safer assets. However, Domestic Institutional Investors (DIIs) have remained consistent buyers, injecting $7.4 billion in February, marking their 19th consecutive month of inflows. Robust SIP participation and steady retail inflows have helped absorb some of the FII-driven pressure, though the market remains vulnerable to external shocks.

Earnings Downgrades Hit Multi-Year Highs

Earnings growth in Q3FY25 remained modest, with the MOFSL universe reporting a 6% YoY increase in aggregate profits. More concerning is the rising downgrade trend, which has now reached its worst level since Q1FY21. Sectors such as Capital Goods, Technology, and Real Estate have been particularly affected, witnessing downward earnings revisions. On the other hand, BFSI and select consumer-driven industries continue to demonstrate resilience, providing a silver lining amid broader market weakness.

Our View

With foreign outflows continuing and earnings growth slowing, near-term volatility is likely to persist. However, historical data suggests that markets tend to stabilize post such corrective phases. Investors should focus on high-quality, fundamentally strong stocks, particularly in the large-cap space, to manage the ongoing turbulence. While midcap and smallcap valuations have moderated, they still trade at a premium, warranting a cautious stance.

Note 2- Valuation Adjustments and Investment Strategy in a Volatile Market

Valuations Reset but Divergence Remains Across Segments

The ongoing correction has resulted in a significant valuation adjustment across indices. The Nifty-50 now trades at a forward P/E of 18.6x, which is 9% below its long-term average. However, despite recent declines, broader markets remain elevated. Midcaps and smallcaps continue to trade at a 22% and 25% premium, respectively, to their long-term historical averages, highlighting the risk of further corrections if earnings fail to catch up.

Sectoral Performance – Gainers and Laggards

Sector-wise, private banks and metals have shown relative resilience, while autos, real estate, and capital goods have experienced sharper valuation declines. The Technology sector, despite recent underperformance, continues to command a valuation premium, driven by long-term structural demand for AI and cloud-based services. Meanwhile, the Oil & Gas sector remains subdued, with crude oil prices stabilizing at lower levels, impacting refining margins.

Market Cap-to-GDP Ratio Indicates Cooling Valuations

India’s market cap-to-GDP ratio, which peaked at 146% in September 2024, has now fallen to 120%, bringing it closer to historical averages. Largecaps have seen the sharpest valuation corrections, while midcaps and smallcaps continue to trade at elevated levels. This suggests that while largecaps offer better downside protection, broader markets may still see some valuation compression before stabilizing.

Investment Strategy – Positioning for Stability

Given the current market environment, largecaps offer better downside protection and more reasonable valuations, making them the preferred bet. Sectors such as BFSI, Consumption, and Healthcare continue to offer attractive opportunities, while caution is warranted in cyclicals such as Automobiles, Metals, and Cement, which remain under pressure from input costs and weaker demand. Investors should focus on stocks with strong earnings visibility and stable cash flows, avoiding excessive exposure to volatile midcap and smallcap segments.

Our View

The ongoing correction, while painful, is creating selective accumulation opportunities. Largecap stocks with strong balance sheets and stable earnings growth should be the core focus for investors. While broader markets may see further valuation resets, disciplined investing in quality businesses will help take advantage this volatile period. Investors should remain patient and adopt a long-term, quality-focused approach to benefit from the eventual recovery.

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