RBI's warning: Indian equities risk being overvalued, earnings may not justify prices

India’s stock markets are showing signs of overvaluation, especially in the small- and mid-cap segments, the Reserve Bank of India (RBI) warned in its latest Financial Stability Report (FSR). The central bank’s concerns come at a time when global economic growth remains uncertain, and corporate earnings may struggle to keep up with market expectations.The apex bank noted that current asset prices, both in India and globally, are running well ahead of economic fundamentals, driven by optimism that may not be justified in the present climate. To justify current valuations, corporate earnings will have to grow at a strong pace, which may be difficult in an uncertain economic environment, the report stated, quoted by ET.According to the FSR, while the Nifty Midcap 100 index is projected to grow at 17.4%, it would require a growth rate of 28% to fully support current valuations. Similarly, the Nifty Smallcap 100 is expected to grow at 16.9%, but needs a 30.6% expansion to be fairly priced.Nilesh Shetty, portfolio manager at Quantum Advisors, said valuations had already corrected earlier in the year but have since rebounded sharply. “We are definitely seeing froth in the small and midcap stocks. The Indian markets did correct much before the tariff uncertainties and there was a significant correction in the small and midcap space, primarily because of valuations,” Shetty told ET. “But there has been a significant rebound and we are very near to the all-time high, despite the global uncertainties. Earnings in Q1 could also be slower than expected.”Siddarth Bhamre, head of institutional research at Asit C Mehta, also noted that while midcaps are currently trading at a premium due to high growth potential, the sustainability of this growth remains in question. “But is this growth high for just 1-2 years or in the longer term?” he said.He also flagged the limited availability of high-quality mid- and small-cap stocks as a reason for stretched valuations. “People are ready to buy quality stocks at much higher multiples in the mid and smallcap segments and quality names here are not enough. There would always be some pockets and some names where we would find good value, but the job of identifying these names is getting difficult everyday,” Bhamre added.The RBI’s report further cautioned that if earnings fail to meet expectations, or if valuations begin to revert, it could have a major impact on the market, particularly in the midcap space.The overvaluation risks aren’t limited to India. The FSR also pointed out that asset prices in several global markets remain high relative to fundamentals. In the US, for instance, the Nasdaq is forecast to grow at 19.9% but would need to post 26% growth to justify current levels.“Price corrections and elevated volatility of US equities can spill over to other markets, especially emerging markets like India,” the report said, highlighting the interconnected risks in the global financial system.