CNBC's Inside India newsletter: The secret of the stock market rally

This report is from this week's CNBC's "Inside India" newsletter which brings you timely, insightful news and market commentary on the emerging powerhouse and the big businesses behind its meteoric rise. Like what you see? You can subscribe here.

The big story

A man counts Indian rupee banknotes for a photograph near the Bombay Stock Exchange (BSE) building in Mumbai, India.

Dhiraj Singh | Bloomberg | Getty ImagesA man counts Indian rupee banknotes for a photograph near the Bombay Stock Exchange (BSE) building in Mumbai, India.

Squirreling away a portion of one's income for a rainy day would typically be considered prudent behavior. Yet, in India, it's helping make stocks overvalued.

Systematic Investment Plans (SIPs) were introduced to help investors periodically put aside money in a disciplined manner. SIPs deduct cash every month from an investor's bank account and invest the proceeds into selected mutual funds.

Strong and persistent marketing of the program over the past decade has meant that 90% of all contributions into domestic equity mutual funds last year were through SIPs. Contributions also hit a record high of 204 billion Indian rupees ($2.5 billion) in April, according to data from the Association for Mutual Funds in India.

While the program's benefits are apparent, from reducing friction for investing to removing the need to time the market, SIPs have also been partly responsible for pushing Indian stock markets to record valuations since they force fund managers to buy stocks regularly.

For instance, while the portfolio managers of India's three largest multi-billion-dollar equity funds, the SBI Equity Hybrid Fund Regular Growth, HDFC Mid-Cap Opportunities Fund-Growth, and ICICI Prudential Balanced Advantage Fund, have sufficient leeway to hold incoming deposits as cash temporarily, their hands are often tied by their mandates to keep the funds fully invested.

As more money is directed toward these funds monthly,  the portfolio managers are forced to buy stocks even when their valuations might not be as attractive.

"This particular product, and broadly speaking, the domestic investor, has driven the upsurge in the Indian stock markets," Mahesh Nandurkar, head of India research at Jefferies, told CNBC. "If the money comes into the funds, the fund managers obviously have to invest."

He added that along with the rapid growth in the underlying economy and company earnings, the SIPs had "driven up valuations for sure."

Lofty valuations have meant that value funds such as Federated Hermes' $3.1 billion Asia ex-Japan fund or Schroders' Emerging Markets Value fund have been largely forced to sit out of the Indian equity market. Jonathan Pines, who runs the Federated Hermes fund, has previously said that India's mid-cap stocks are in a "bubble" despite the country's promising economic prospects.

For instance, of the nearly 4,900 actively traded India-listed stocks, 300 stocks had a fall in revenue in the last two consecutive financial years. Yet, 216 of these stocks rose over the past 12 months, according to CNBC's count of FactSet data.

In fact, small-cap companies such as food packaging carton manufacturer Rollatainers and Tantia Constructions, an infrastructure company focused on railways, bridges, roads, and airports, have had three years of falling growth. Yet, their stock has risen more than 300% over the past 12 months.

Having said that, the positive impact of SIPs appears to outweigh the negatives, for now.

Foreign investors have historically had a significant influence on local equity markets. The largest stock indexes, the Nifty 50 and Sensex, have suffered declines and fund outflows when financial conditions have tightened abroad, even if the index's constituent companies and the Indian economy have been largely insulated.

As the domestic investor base continues to grow, turbulence in foreign markets will likely have a more negligible impact in the future.

Deepak Jasani, head of retail research at HDFC Securities, said that fund flows from 87 million investors investing about $32 every month "helps reduce volatility caused by [foreign portfolio investment] outflows and helps to boost valuations when FPI flows are positive or neutral."

There's more to come. For now, the savings directed into equity markets are still a tiny proportion of the overall savings Indians put away annually.

According to Jefferies, Indians save about 18% of GDP, or about $800 billion yearly. Of this, only $40 billion — or 5% — is estimated to flow into equities through SIPs, insurance, and pension schemes.

As investors become more comfortable investing in the stock market, the proportion of savings and an increase in the total amount saved will likely send more money toward that asset class.

"While India is a low-income country, it's still a very high savings economy," Jefferies' Nandurkar added.

Need to know

India's central bank approves the highest-ever dividend to the government. The 2.11 trillion rupee cash injection, announced on Wednesday, was significantly above analysts' and government projections. It will alleviate the need for New Delhi to borrow funds in the market and help it manage any welfare and capex spending.

Volkswagen in talks to 'partner' up on passenger car production. The German automaker already operates two plants in India. The group's statements partly reflect concerns about the risk of an escalating trade war between Washington and Beijing and the possible implications for European carmakers, most of which heavily rely on the Chinese market.

Modi's strongman rule raises questions about India's 'democratic decline.' India's economic growth has been robust and its geopolitical standing in the world has risen under Prime Minister Narendra Modi's first two terms in office. But the country has also witnessed signs of democratic backsliding which has become apparent during his leadership, observers and critics say. The Sweden-based V-Dem Institute said a third Modi term could worsen the political situation due to the "enduring crackdown on minority rights and civil society."

Bank of America names 3 Indian stocks among Asia's 'most important.' [Subscriber content] An industrial giant, one of the largest private banks, and an IT company made the Wall Street bank's list. Back-testing shows that the investment bank's list of top stocks "would have outperformed in 16 of the last 29 calendar years"

What happened in the markets?

Indian stocks rallied again by more than 2% this week. The Nifty 50 was up about 2% last week too, and the index has risen 5.7% this year.

The benchmark 10-year Indian government bond yield has fallen below 7% for the first time this year. Bond markets now expect India's deficit to be below what was previously priced in due to the record central bank dividend described above.

On CNBC TV this week, we had Amit Jain of Carlyle India Advisors. Jain said political stability and strong market fundamentals are making India's private equity market look attractive.

And CNBC's Sri Jegarajah reported on the Mumbai-Ahmedabad high-speed rail that aims to cut travel time between the two busy cities by up to two-thirds. The project, which was approved in 2014, has faced several setbacks.

What's happening next week?

The Indian election enters its seventh and final phase of voting next week. Results are expected to be announced after counting begins on June 4.

On the data front, it'll likely be a quiet week, with U.S. markets closed on Monday, May 27. Shares of Awfis, the co-working and office space provider, will debut on Thursday.

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