Market valuations fall below historical averages: Is it time to reconsider investment strategies?

In recent months, the benchmark stock indices, the Sensex and Nifty 50, have experienced notable declines of 11% and 12%, respectively, from their peak levels. As a result, their price-to-earnings (PE) ratios, measured on a trailing 12-month (TTM) basis, have dropped below their 5-year and 10-year averages.

At present, the Sensex is trading at a TTM PE of 22.2x, which is lower than its 5-year average of 25.4x and 10-year average of 27.5x. Similarly, the Nifty 50 is trading at a TTM PE multiple of 21.7x, compared to its 5-year average of 23.9x and 10-year average of 26.7x.

Analysts attribute this decline in PE ratios to underwhelming corporate earnings for the December 2024 quarter (Q3-FY25), which have contributed to the recent market correction.

U R Bhat, co-founder and director at Alphaniti Fintech, suggests that further downside in the markets is likely, as the current valuation levels do not fully reflect the ongoing slowdown in corporate earnings growth and a cautious outlook for the future. Global factors are also playing a role in this sentiment, Bhat noted, and require close attention.

“The market still has more challenges ahead. The cautious tone from companies reporting Q3-FY25 results and expectations of slower earnings growth in the coming quarters are dampening sentiment. Investors would be wise to remain on the sidelines for at least one quarter, watch how the budget impacts the market, and observe how corporate earnings unfold,” said Bhat.

Midcap and small-cap stocks have faced similar pressures, with the Nifty Midcap 100 and Nifty Smallcap 100 indices showing a decline in their PE ratios, now standing at 37.1x and 26.6x, respectively. These stocks have seen sharper corrections than their large-cap counterparts.

According to data from the National Stock Exchange (NSE), the Nifty Midcap 100 index is down around 13% from its peak, while the Nifty Smallcap 100 index has fallen by 15.5%.

Looking at historical trends, analysts from Nuvama Institutional Equities warn that investors may need to brace for a prolonged downturn in these market segments, pointing to previous bear markets in 2011–13 and 2018–19. They argue that the current market dynamics are reminiscent of a bear market, with a slowdown led by domestic credit and profits in the small- and mid-cap sectors (excluding BFSI) now showing contraction.

During past bear markets, sectors such as industrials, renewable energy, non-bank finance companies, and public sector banks suffered significant losses, with some stocks already seeing corrections of over 50%. Despite these declines, valuations in these sectors remain high, and analysts caution that elevated margins make them vulnerable to deeper earnings cuts, especially amid a demand slowdown.

Nuvama notes that while liquidity in the market has become tighter, it is essential to monitor policy shifts that could trigger a reversal. They also highlight that valuations in the mid- and small-cap sectors are still one standard deviation above their long-term averages, suggesting that more downside could be ahead.

From an investment perspective, Nuvama’s analysts recommend focusing on exporters, where the downturn has already taken a deeper toll, and domestic laggards in sectors such as cement, durables, quick-service restaurants (QSR), and retail, where low margins are prompting corrective actions.