Nifty is at record high, but more gains likely

The question would seem pertinent given that on Thursday, the Nifty hit a record high, and indices that track smaller stocks hovered just below their respective record levels.

While the Nifty is currently trading at an averaged valuation of price-to-earnings (PE) ratio of 22-23 times, smaller stocks are somewhat more expensive with the Nifty Midcaps 150 and the Nifty Smallcaps250 trading at average valuations of PE24-25.

The market's resilience seems to defy fundamental logic, revealing the potent role of investor sentiment and its capacity to trigger what some describe as "reflexivity", a theory developed by billionaire investor George Soros.

Despite sluggish Q1 profit growth and a patchy monsoon season weighing on rural sentiment, investors are optimistic, partly buoyed by snippets of positive economic news from the US.

Recent consumer inflation and consumption numbers out of the US align with market expectations, fueling hopes that the US Federal Reserve will maintain its current policy rates. Such a pause, investors anticipate, would influence the Reserve Bank of India (RBI) to similarly hold off on rate hikes. The RBI has kept its policy rate unchanged in its last three meetings, a stance it may continue given the slight dip in retail inflation in August to 6.83% from 7.44% in July.

The Index of Industrial Production for July has also looked strong at 5.7%, up from 3.7% in June.

The optimism isn't just limited to macro-economic indicators; it's palpable in market behaviors. The primary market is bustling with initial public offerings (IPOs) worth over ₹17,000 crore in the pipeline. Institutional positioning has remained net positive throughout FY24. Foreign portfolio investors (FPIs), although net sellers in September, have been net buyers to the tune of ₹1.58 trillion since April 2023. Domestic institutions have bought a net ₹35,543 crore worth of shares, while equity mutual funds have received net inflows of ₹46,000 crore during April-August. Retail investors, who primarily operate in the mid-cap and small-cap space, have shown similar bullish sentiment.

Yet, how much of this enthusiasm can be justified? 

Second quarter earnings will start in early October will offer insight into growth acceleration and whether it meets or surpasses investor expectations. The timing coincides with the RBI's next monetary policy meeting and the onset of the festival season, starting with Navratri, which is traditionally a catalyst for consumer spending across industries like automobiles and jewellery.

One must note that this optimism could break down if the Fed decides to hike rates. If that doesn’t happen and the market continues to trend up, market watchers should pay heed to George Soros’s theory of reflexivity.

Soros, whatever you may think of his politics, has been a super successful investor and trader. He explains reflexivity as follows: The vision of market participants is always partial and distorted. Those distorted views influence their actions, which in turn, causes feedback loops.

That is, if the market is trending up, and participants are optimistic, they will buy more, pushing the market up beyond fair valuation, as more and more optimism will prevail as the market goes up. Conversely, if sentiment is downbeat, and the market is bearish, pessimism will push prices lower and lower. As a result of this reflexivity, bull market prices always overshoot fair valuation and bear market prices always drop below fair valuation.