CNBC's Inside India newsletter: Unveiling the Stock Market Rally's Mystery

This report is from the CNBC "Inside India" newsletter, which provides timely and insightful news and market commentary on the emerging powerhouse and the big businesses driving its rapid growth. If you find it interesting, you can subscribe here.

The big story

In India, saving a portion of one's income for future use is considered prudent behavior, but it is also contributing to the overvaluation of stocks.

Introduced to assist investors in regularly saving money in a structured way, Systematic Investment Plans (SIPs) automatically withdraw cash from an investor's bank account monthly and invest it into chosen mutual funds.

Over the past decade, the program has been heavily marketed and has resulted in 90% of all contributions into domestic equity mutual funds last year being made through SIPs. In April, contributions reached a record high of 204 billion Indian rupees ($2.5 billion), according to data from the Association for Mutual Funds in India.

SIPs have contributed to the rise of Indian stock market valuations by compelling fund managers to purchase stocks frequently.

The portfolio managers of India's three largest multi-billion-dollar equity funds, SBI Equity Hybrid Fund Regular Growth, HDFC Mid-Cap Opportunities Fund-Growth, and ICICI Prudential Balanced Advantage Fund, have the flexibility to hold incoming deposits as cash temporarily, but their mandates require them to keep the funds fully invested.

As more money is allocated to these funds, portfolio managers are compelled to purchase stocks, even if their valuations are not as appealing.

"The Indian stock markets have experienced an increase due to this specific product and the domestic investor, as stated by Mahesh Nandurkar, head of India research at Jefferies, in an interview with CNBC. As a result, when funds are invested, fund managers must allocate the money accordingly."

The SIPs contributed to the increase in valuations due to the strong economy and company earnings.

Due to lofty valuations, value funds such as Federated Hermes' $3.1 billion Asia ex-Japan fund and Schroders' Emerging Markets Value fund have been unable to invest in the Indian equity market. Despite India's promising economic prospects, Jonathan Pines, who manages the Federated Hermes fund, has previously stated that the country's mid-cap stocks are in a "bubble."

Despite a decline in revenue for 300 India-listed stocks in the past two financial years, 216 of these stocks experienced growth over the past 12 months, according to CNBC's analysis of FactSet data.

Despite three years of declining growth, small-cap companies such as food packaging carton manufacturer and an infrastructure company focused on railways, bridges, roads, and airports have experienced a more than 300% increase in their stock prices over the past 12 months.

The positive effects of SIPs seem to outweigh the drawbacks, at present.

Historically, foreign investors have had a substantial impact on local equity markets, with the largest stock indexes, such as and , experiencing declines and fund outflows when international financial conditions tighten, even though the index's constituent companies and the Indian economy have largely remained unaffected.

In the future, as the domestic investor base expands, the influence of foreign market turbulence is likely to diminish.

According to Deepak Jasani, head of retail research at HDFC Securities, the $32 monthly investments from 87 million investors help reduce volatility caused by foreign portfolio investment outflows and boost valuations when FPI flows are positive or neutral.

Despite the increase in savings directed towards equity markets, they still represent a small fraction of the total annual savings of Indians.

According to Jefferies, Indians save approximately 18% of their GDP, which amounts to around $800 billion annually. Out of this, only about 5% or $40 billion is believed to be invested in equities through SIPs, insurance, and pension schemes.

As the stock market gains more investor confidence, the percentage of savings allocated to this asset class is likely to rise.

Despite being a low-income country, India has a high savings economy, according to Jefferies' Nandurkar.

Need to know

The Indian central bank has approved the highest-ever dividend to the government, with a 2.11 trillion rupee cash injection announced on Wednesday. This exceeded analysts' and government projections, providing relief to New Delhi as it will no longer need to borrow funds in the market and can manage any welfare and capex spending.

Volkswagen is in discussions to collaborate on the production of passenger cars in India, where the company already has two operational plants. The group's statements partially reflect worries about the potential consequences of an escalating trade war between the US and China, as well as the impact on European automakers, who heavily depend on the Chinese market.

The third term of Prime Minister Narendra Modi could worsen India's political situation, according to the Sweden-based V-Dem Institute, which has raised concerns about the country's democratic decline. Despite India's robust economic growth and rising geopolitical standing, observers and critics have noted signs of democratic backsliding under Modi's leadership.

The Wall Street bank has named three Indian stocks as among the most important in Asia. The list includes an industrial giant, a private bank, and an IT company. 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?

This week, Indian stocks surged by more than 2%, with the Nifty 50 increasing by approximately 2%. Additionally, the index has experienced a 5.7% rise in value throughout the year.

India's 10-year government bond yield has dropped below 7% for the first time in 2021, and bond markets anticipate that the country's deficit will be lower than previously predicted due to the record central bank dividend.

This week on Biz Focus Hub, Amit Jain of Carlyle India Advisors discussed how India's private equity market is becoming increasingly attractive due to its political stability and strong market fundamentals.

The Mumbai-Ahmedabad high-speed rail, which aims to reduce travel time between the two cities by up to two-thirds, has faced several setbacks since its approval in 2014. CNBC's Sri Jegarajah reported on the project's challenges.

What's happening next week?

The seventh and final phase of voting in the Indian election will take place next week, with results anticipated to be declared following the commencement of counting on June 4.

This week on the data front is expected to be relatively calm, with U.S. markets closed on Monday, May 27. On Thursday, Awfis, a co-working and office space provider, will make its stock market debut.