Is the Indian stock market overvalued? Will the correction continue?

Let’s look at a few indicators:

𝟭. 𝗕𝘂𝗳𝗳𝗲𝘁 𝗜𝗻𝗱𝗶𝗰𝗮𝘁𝗼𝗿
Market Cap to GDP is over 130% i.e., Market Cap exceeds GDP by 30%
Up until 2020, this indicator was below 100% (except in 2007). Over the last 3 years,, this indicator has been rising and is now above 130%.

𝟮. 𝗚𝘀𝗲𝗰 𝗮𝗻𝗱 𝗜𝗻𝗱𝗲𝘅 𝗘𝗮𝗿𝗻𝗶𝗻𝗴 𝗬𝗶𝗲𝗹𝗱
Earnings yield = 1 / Sensex P/E = 1 / 22.6 = 4.4%
10 Year Govt sec yield =~ 7%
Gap = 7% – 4.4% = 2.6%
This gap between 10Y G-sec yield and earnings yield has remained at elevated levels

Expectations of high decadal GDP growth, healthy corporate earnings and de-levered balance sheets — have driven these premium valuations on the back of strong inflows from domestic investors.

𝟯. 𝗜𝗺𝗽𝗹𝗶𝗲𝗱 𝗘𝗾𝘂𝗶𝘁𝘆 𝗥𝗶𝘀𝗸 𝗣𝗿𝗲𝗺𝗶𝘂𝗺
ERP in a country is the price of risk of investing in equities in that country or said another way it is the additional return (over the risk free rate) that investors expect for taking the risk of investing in that market.

Risk Free Rate = 10 year govt bond yield = 7% (disregarding credit risk embedded within the govt bond for simplicity)
ERP = 7% (per historical market returns, ERP in India is 6-8%)
So, typically India market return expectation = RFR 7%+ ERP 7% = 14%

Market index is the present value of expected cash flows from the companies that make up the index.
Per my rough calculation — after backing out ERP from the current value of BSE Sensex — the implied ERP in India is negative.

𝙒𝙝𝙖𝙩 𝙙𝙤𝙚𝙨 𝙖 𝙡𝙤𝙬 𝙤𝙧 𝙣𝙚𝙜𝙖𝙩𝙞𝙫𝙚 𝙀𝙍𝙋 𝙢𝙚𝙖𝙣?
Investors are incentivized to invest in developing markets (over developed) for higher returns — this is because the risk (and hence the return premium) in developing/emerging markets is higher than the risk in equities in a mature market like the US.
Now the reverse is happening i.e., ERP in India is lower than the ERP in the US (which is ~4% currently)


This indicates that a potential (or rather a continued) market correction.